In order to make better decisions, we need to be keenly aware of the biases that affect our decision making. Here are three that every investor should constantly bear in mind.
1. Confirmation bias.
Let’s face it. We all want to be right as often as possible. No one enjoys being told that they are wrong. Nobody likes to read about things that could imply that they are wrong. None of us ever want to be wrong, if we can possibly help it. Beside the psychological feel good factor about being right, being right is also economical on the thought process. Being right is the end game, but being wrong implies that there is a ‘Right’ out there waiting for us to recognize and process. It is tiring to be wrong, or even to entertain that thought that we could possibly be wrong.
Hence the confirmation bias. We seek out evidence to confirm that we are right while at the same time denouncing other factors that could point to us being wrong. This bias is abound in many aspects of our lives. If you are a religious person and believe in the existence of a certain God, chances are you will not bother to study the teachings of other religions, but rather seek to confirm your already unshakable faith by attending services and ceremonies, reading material from the same source, and surrounding your cliche with friends of the same belief. The same goes for political and sporting affiliation, where we would be resistant to, and constantly downplay any negativity surrounding the parties and teams we are rooting for.
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The bias is unmistakable in investing. Alvin and myself were trading in Research in Motion (RIMM – BBRY) shares about a year ago. He was optimistic and considered the stock to be undervalued and irrationally sold down considering their huge cash stash. I was fully negative on the prospects of the company and considered it to be going the way of the Dodo – extinct soon. BBRY happened to be followed by many analysts and I ended up spending huge amounts of time on the web reading reports of the company. On hindsight, I realized that the reports and analysts I followed were all bearish. The effort I put in to make me feel good only served to make myself feel better but did nothing to enhance my overall awareness of the company and did nothing to allow me to make better trades.
2. Loss Aversion bias
Another undisputed fact: We all hate losing. Some of us more than others, but basically, we all hate losing.
Imagine the following scenario. You have bought shares of Creative Technologies a decade ago when it was the undisputed market darling and breaking new highs every week. Unfortunately it has since fallen on hard times and the share price is barely a fraction of what it used to be. However, the loss is just too painful to bear and you have put off selling the stock for years and years on end.
One day however, you receive a statement from your broker stating that a trading glitch occurred and that you Creative Holdings have been mistakenly disposed off. The brokerage is offering to buy back the shares for you at no charge and just needs your consent. Would you give the consent? My guess is that you would simply let it pass. Chances are you would be relieved that someone else has pulled the trigger for you and happy for the extra amount of money you find in your bank account from the sale.
That is Loss Aversion at work for you. Losses are deemed much more painful than unfulfilled gains, and we tend to avoid them at all cost. Because of Loss Aversion, we end up hanging on to our losing trades when we should have cut our losses and moved on. Such behavior is unbecoming, but sadly, extremely common amongst investors.
3. Overconfidence Bias
As the name suggests, the bias occurs because human beings tend to be more confident in our subjective judgements than the actual objective accuracy. This happens across all aspects of our lives. We tend to think that we are better drivers than most people around us, we figured that we are the better workers in the company/department, and we are all extremely certain that the stock that we just bought will be a multi-bagger.
In reality, our driving skills are average at best, others work just as well as we do, and our stock picking abilities certainly do not rank higher than most otherwise we will be making a very good living out of it.
As traders and investors it pays to constantly remind ourselves to search for disconfirming evidence, maintain proper cut loss levels and take losses when necessary and most importantly, guard against overconfidence. Being aware of and overcoming these biases will lead us to make better financial decisions!