Men, by nature, are flawed. And one of the flaws is the numerous biases that we succumb to. We are biased people. Biases warp and contort our rationality. They result in baseless perceptions upon which our actions and omissions are based.
What makes it difficult to recognise these biases for what they are is the fact that they are often unconscious biases. That is why decent and upright men too have their baseless biases. Biases plague all aspects of our lives. They cast a thinly veiled shroud upon our thought processes and blinker our subsequent actions and reactions.
Especially when investing in stocks, biases can significantly affect decision-making, often leading to suboptimal investment outcomes. Behavioural finance, a field that examines the influence of psychology on financial markets, identifies numerous biases that impact investors.
Here are three of the most prevalent biases in stock investing:
Confirmation Bias
Confirmation bias refers to the tendency to search for, interpret, favour, and recall information in a way that confirms one's preexisting beliefs or hypotheses. Investors often seek out information that supports their investment choices and ignore or downplay data that contradicts them. We do not hear both sides of the story.
We start off clouded with strong prejudices. We are opposed to having an open mind to consider two opposing points of view.
As a result, our thought processes are biased; We end up making a biased informed investment decision.
Confirmation bias impacts investing in three ways.
Firstly, there is selective information gathering. Investors may only read analyses or reports that support their current holdings or investment strategies, leading to a skewed perception of an investment's potential.
Secondly, confirmation bias breeds overconfidence. By focusing only on supportive data, investors may become overconfident in their decisions, ignoring potential risks or alternative viewpoints.
Finally, confirmation bias may result in inadequate diversification: Confirmation bias can lead investors to concentrate their portfolios in certain stocks or sectors that have performed well for them in the past, increasing risk.
But there are mitigation strategies. One is to Seek diverse opinions: one should actively seek out analyses and viewpoints that challenge your current beliefs. This can help in gaining a more balanced understanding of the investment landscape.
Structured decision-making through the use of a systematic approach to evaluate stocks, such as setting predefined criteria for buying and selling, can help reduce the influence of subjective biases.
Engaging in regular education about cognitive biases and behavioural finance helps. And then there is continuous learning to help us become more aware of the bias tendencies.
Herd Mentality
Herd mentality, or herd behaviour, refers to the tendency of investors to follow and mimic the actions of a larger group. This bias is driven by the assumption that a large group's collective decision must be correct. There is comfort in numbers. This mentality is utterly un-contrarian.
Even research analysts suffer this bias. The technical investor relies on herd mentality. But it has no place for the fundamental investor.
Herd mentality contributes to the formation of asset bubbles as investors collectively push prices beyond intrinsic values based on the belief that current trends will continue indefinitely. Consequently, in a downturn, herd behaviour can lead to panic selling, where investors sell off assets en-masse, often at a loss, in fear of further declines.
Following the crowd can reduce the incentive to conduct thorough research and due diligence, leading to poor investment decisions. There will be reduced analytical rigour.
The antidote for herd behaviour is sound independent analysis. Focus on conducting independent research and analysis to form your own investment thesis, rather than relying on market trends or the actions of others. Read widely, hear many - but decide on your own.
Maintain a long-term perspective on investments to avoid getting swayed by short-term market movements and the actions of others. Find comfort, courage and confidence in taking a contrarian approach, where you actively look for opportunities that are undervalued due to being overlooked or avoided by the majority.
Loss Aversion
Loss aversion is a cognitive bias where the pain of losing is psychologically more impactful than the pleasure of gaining. This can lead investors to irrationally avoid losses, sometimes at the expense of potential gains.
Loss aversion ends up with us holding losing stocks. Investors might hold onto losing stocks longer than is rational, hoping to "break even" rather than realizing a loss. And this can lead to even greater losses.
Conversely, investors may sell winning stocks too early to "lock in gains," missing out on further potential upside. Loss aversion can lead to overly conservative investment strategies, where investors shy away from higher-risk, potentially higher-reward opportunities.
We can mitigate the loss aversion by selling a stock when it reaches a predetermined price.
Stop-loss orders can help manage losses by automatically selling the stock at a predetermined price.
Rather than focusing on individual winners or losers, evaluate the performance of your entire portfolio over a reasonable time horizon.
As investors, we need to reframe thinking. We need to train ourselves to view losses as a natural part of investing and focus on the long-term growth potential rather than short-term fluctuations.
Understanding and mitigating biases is crucial for effective stock investing. These biases often lead investors away from rational decision-making, resulting in suboptimal outcomes.
By being aware of confirmation bias, herd mentality, and loss aversion, investors can take proactive steps to minimize their impact.