Being successful at investing isn’t only about understanding businesses, following news, being good at math and upping your patience game. It is also about getting your mental game right; to enable making the right decisions at the right time.
In getting this right however, we frequently face hurdles or even make mistakes. And very often these are not related to investing, but are to decision making. These mistakes are associated with us acting in ways that are harmful, but a result of basic human instinct.
And when you are cognisant of these biases, it is easier to be able to consciously avoid them, and focus on making decisions objectively.
Common biases to avoid:
Cognitive Biases (fallacies in reasoning - just the way human brains are wired)
Anchoring "Never judge a book by its cover," yet it is common nature to do so, as first impressions matter. The human tendency to make decisions based on the first piece of information we receive is the Anchoring bias. Investors often retain information that may no longer be relevant and base their decisions on it solely because it was the first thing they registered, leading to them disregarding anything else that might be relevant. For example, you’re at the mall and pick a t-shirt you like. The tag says “50% OFF” in bold letters, and the original price (which has multiple zeros) is mentioned above it. Naturally, you perceive the deal as a steal and proceed to the check-out without hesitation. This is due to the fact that the discount makes the product seem more affordable and raises the deal's perceived value in the eyes of the customer. Fun fact: The “original price” is usually artificially raised to make the discounted price seem reasonable.
Confirmation Bias The confirmation bias refers to our proclivity to give more weight to evidence that supports our pre-existing beliefs. Since evaluating evidence takes time and effort, our brain seeks shortcuts to make the process more efficient (surprise surprise). Many investors, for example, form an opinion and then seek information to support that opinion. Let's say a potential investor learns that a business is allegedly close to filing for bankruptcy. When they visit the internet , they only read the articles that reiterate the likelihood of bankruptcy and fail to notice a story about a promising new innovation the business recently introduced. The investor decides to sell the stock, and to their horror, the business recovers and hits an all-time-high (oops).
Hindsight Bias Also referred to as the 'knew-it-all-along' effect. We have a tendency to look back on an unexpected event and believe it was easily predicted. We cannot learn from our experiences because of this bias. It results in an overconfidence in one's capacity to foresee other future events and may cause one to take unwarranted risks. These people can be spotted saying “I told you so” repeatedly. A notable example is when financial bubbles burst. Consider the current market decline; many finance pundits on LinkedIn and Twitter cite past events as evidence that the markets were "at the top" at the time. They are accurate, but at the time other events confirmed the belief that the gains would keep coming in. In fact, if financial bubbles could be easily recognised, they would not cause as much catastrophe.
Behavioural Biases (s**t going down when emotions come in the way!)
Disposition Bias We are motivated to sell winning investments to earn profits, but we are hesitant to sell losing investments in the hopes of turning them into winners. This effect is also consistent with the sunk cost fallacy, which is our inclination to continue directing resources, whether time, money, or material, toward a lost cause. Let’s say you are an investor with two companies in your portfolio; A & B. Since you bought it, the value of Company A has increased. Company B is performing worse than when you invested in it. You believe that the profit you made from Company A are satisfactory and perhaps Company B’s fate will change. Hence, you hold onto it for a little while longer. Company A rises further and Company B falls further, leaving you distraught.
Regret Aversion Regret can be a helpless and unpleasant state, and many people live their lives in fear of them. As a result, decisions are made to avoid regretting a previous decision in the future. As a form of emotional insurance, we frequently factor in the possibility of regret for making the wrong decision. This often leads to impulsive investment decisions, which ironically leads to regret anyway. This is best illustrated by FOMO (Fear Of Missing Out) investing. A Reddit influencer mentions a multi-bagger that has already generated sizable returns. You want to follow the trend and profit along the way. You put some money into it with the intention of becoming wealthy, but in some time, BOOM, it's all gone. You become a victim of a pump and dump scheme as the adrenaline wears off.
Bandwagon Effect We’ve all heard the famed justification given to us by the elderly - “if your friend jumps in the well, would you?” - when you wish to go out to the movies on a week day. Unfortunately, this applies to the market, wherein a majority of the investors are prey to the influence of others, without a thought behind those research-less eyes, leading to mass hysteria reactions. During the pandemic, we witnessed the unfortunate shortage of oxygen at inopportune times, resulting in the market recognising that oxygen is a scarce resource and felt the need to buy shares of Bombay Oxygen Investments Ltd, leading to a 256% surge in their price! The irony? They don’t produce oxygen anymore.