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Most investors tend to overestimate their own ability to generate high returns. Successful investors, however, tend to acknowledge their limitations and “biases” (i.e. psychological traits which can lead to errors of judgement). Learning to recognise and manage these biases is key, therefore, when following a long-term investment strategy. Here at WMM, in this article we share five common biases to be mindful of when investing.
#1 Bandwagon effect
Humans are, by nature, social creatures. Even if some people describe themselves as “loners” or introverts, we all usually feel more at home when we sense that we belong to a larger “clan”, “herd” or group. Whilst this is helpful to us in the wild, it can hinder us in the investment world. When large numbers of people flock towards a “hot investment” (e.g. a surging cryptocurrency), it takes discipline to resist the urge to follow and think independently. Remember, just because the majority seems to think something is a good idea, doesn’t mean it is!
#2 Anchoring bias
Numerous studies suggest that humans rely on “significant” past events – or previous choices – when deciding what to do next (e.g. picking an investment). With stock investing, for instance, we are tempted to use the past stock price as an indication of where it will be in the future. Yet the past value of a stock is not an indication as to whether it is “cheap”, “expensive” or a good investment (or not).
#3 Probability neglect
We can all be vulnerable to the mistake of overestimating – or underestimating – the probability of something happening (e.g. the future value of an investment fund). This is partly due to the “hindsight” bias effect. For instance, suppose you are dealt a terrible hand in a game of poker. From that point, many people assume that they are less likely to be dealt an equally terrible hand again, in the near future. Yet the fact that this happened one time does not change the likelihood of it happening again. The same holds true when investing. Just because a stock or fund did well/badly in the recent past, does not mean it is more likely to repeat this again.
#4 Loss aversion
Humans typically feel the pain of a loss more keenly than they experience the joy of a “win”. In fact, if given the choice, most would prefer to minimise the risk of feeling pain (e.g. losing money on an investment) rather than chance the pleasure of a gain. This loss aversion can lead people to make silly investment mistakes.
For instance, perhaps an investor does not let go of a “poor” investment when the time is right, due to the “endowment effect” (i.e. placing higher value on a good that the investor owns compared to an identical good that they do not own). Or, maybe an investor does not commit funds to a sound investment because he/she is unreasonably fearful of making an investment loss (which could be mitigated, for instance, by diversifying the portfolio).
#5 Confirmation bias
We all like to read or consume information which confirms what we already believe – e.g. about politics, religion or different investments. It is easy to ignore voices and facts which contradict these cherished ideas, yet doing so can lead to overconfidence in a particular fund, stock or market which later leads to costly mistakes. Here, it helps to have trusted people around you to help question your beliefs and help you see facts you may have missed. A financial planner can play a vital role here.
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