When it comes to investment choices, keep in mind possible investment biases. The Behavioral Finance Theory states that when it comes to decision making, investors act rationally via objective thinking and logic.
Investors act rationally but they can also act irrationally by not being aware of their biases and how they process information. This allows them to make sub-optimal decisions.
Common Investment Biases
- Overconfidence
- Overconfidence bias refers to investors who believe that they’re better than average. It’s a tendency to hold false assessment of our skills, intellect or talent. It’s an egotistical belief.
- Self Attribution Bias
- Refers to investors who attribute their successes to their own personal skills and failures to factors beyond their control. Make sure you identify your strengths and weaknesses when trading as it can help you avoid self attribution bias.
- Hindsight Bias
- Hindsight is always 20/20. Hindsight bias is the tendency of people to say that they “always knew” that they were right after the fact happened. They may assume that they possess special skills to predict the future. To avoid hindsight bias, first be aware of it and if you can, keep a diary in regards to your investment decisions.
- Confirmation Bias
- Beware of this bias when researching investments. This bias is the tendency of investors to pay close attention to information which confirms their beliefs and ignore information against it. We are all prone to confirmation bias – from the news we watch to the websites we visit. We choose to embrace things that reflect our opinion and news.
- Conservatism
- This bias refers to investors who are too slow in responding to new information that might contradict their beliefs. They’re too slow to act immediately.
- Representative Bias
- Occurs when people confuse two objects or events of being similar in nature. It involves stereotyping how close two objects might be related with one or another when it fact, they’re completely different.
- Bob is an opera fan who enjoys touring art museums when on holiday. Growing up, he enjoyed playing chess with family members and friends. Which situation is more likely?A. Bob plays trumpet for a major symphony orchestraB. Bob is a farmer
- A large number of people will guess that Bob will play trumpet when it might be just as likely or more for him to be a farmer as farmer population is greater.
- Framing Bias
- Framing Bias deals with investors tendency to change their decisions based on the way an information is presented to them as opposed to analyzing the facts for themselves. The same fact when presented in two different ways can lead people to making different judgement or decisions.
- In Q2, our earnings per share (EPS) was 1.40 compared to expectations of 1.42
- In Q2, our earnings per share (EPS) was 1.40 compared to Q1 when it was 1.35
Option #2 does a better job of framing the corporate earnings report.
- Anchoring Bias
- Anchoring bias refers to investors who are rely on the first information or facts that they see. For example, if you notice shoes priced at $500 and then see a second one that costs $50, you’ll believe that the second shoes were priced cheaply! That’s anchoring bias. Individuals would use an initial piece of judgement to make subsequent judgments.
- Loss Aversion
- Loss aversion is the tendency by investors to avoid taking a loss on their investments. Investors are willing to take on more risk when they experience losses and take on less risk as they experience gains. For example, we would be more upset about losing $10 then we would be for finding $10. Losses hurt twice as much as gains.
- Herd Mentality
- Also known as the mob mentality which encourages people to act or adopt the same similar behaviors as people around them. When it comes to investing, always be aware of your herd instinct. Make sure you do your own analysis when it comes to investments. Herd mentalities have been known to cause substantial market rallies and extensive sell offs, often on a lack of fundamental support to justify either.
Conclusion
When making investment decisions, keep in mind the common behavioral biases and keep your emotions in check. As Warren Buffet put it, “Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.