Avoid Investment Mistakes: Learn Behavioral Finance

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This story originally appeared on MarketBeat

In college, I studied psychology as a minor. Because they’re so interesting and possibly damaging to us and our money, every time I see an article on heuristic thinking and the availability bias I stop to read it.

Want to see an example of bias? Let’s take, for example, the statement that you made in 1997 about how it was good to invest in Amazon. Your friends and coworkers have heard you tell them that you knew then that Amazon would be a huge company. They look admiringly at your achievements in 2021.

You are probably guilty of the hindsight bias. You view past events as more predictable.

Because we are all human, psychological biases can cause portfolio problems or make trading plans difficult. Let’s look at the many ways that your biases can get in your way.

What exactly is behavioral finance?

Behavioral finance examines how market outcomes can be affected by psychological factors. Behavioral finance can be used to study the impact of psychological biases on investing and help you make better decisions.

We’ll be discussing some common cognitive biases which can affect investing decisions.

Confirmation Bias

Confirmation bias is when you are unable to find information that supports a belief or conclusion you already believe. You might find a handful of positive news stories that make it appear like you should trade the stock. Some people will ignore negative news regarding the company they want to invest.

You might feel that everything will be fine and you may refuse to look at all possible solutions. This is a common problem in politics. People tend to only want positive information about their candidate or side, and ignore negative information or candidates.

Here are some tips to defeat confirmation bias

  • Even if you do not want them to be heard, purposely seek out opposing opinions. Learn the background of why a particular entity or person has chosen to take that stock or company position.
  • Do not rely solely on one source of information. Learn more about investing.

Information Bias

Information bias is the tendency of investors to see all information in relation to trading and investing. Investors and traders see so many information each day from Twitter feeds to market commentary that it can be difficult to discern which information they should keep on their radars and which should be ignored. You could sell great companies or buy in to less-successful ones if you have the wrong information.

Information bias can be overcome with these tips

  • Investors: Don’t pay attention to share prices changing daily.
  • Make sure you are focusing on the most important information for trading and investing. Use sound metrics to find the fundamentals of the company.

Loss Aversion

People are more likely to lose money than make equivocal profits because of loss aversion. If there is a risk of losing money, people will avoid an investment. Irrationally, similar-sized losses can be more costly than gains. Fear of losing investment could cause people to pass on opportunities.

How to defeat loss anxiety

  • Stop levels and targets for trading.
  • Learn patience and how to manage your emotions.

Hindsight Bias

You see past events in hindsight as being predictable, and those from the future as unpredictable. Hindsight bias clouds objectivity. This is how it could look: A stock goes up in price. You “just knew” that it would drop. Let’s suppose you make money from your efforts. You “just knew” that you had made a good decision.

Here are some tips to prevent hindsight bias

  • To learn more, keep an investment journal.
  • You should choose a data-driven, non-emotional approach to investing.
  • Do not be too confident
  • Be prepared for the unexpected.

Groupthink

The bandwagon effect, also known as groupthink, is something you are familiar with. It’s the same thing your mother warned you about: peer pressure. You may be tempted to follow the example of others who have invested or traded in that stock or company.

The short-selling GameStop phenomenon earlier this year offers a great recent example of groupthink, when investors bought GameStop in droves when the news (and social media) shared enthusiasm for GameStop and many other companies.

How to defeat groupthink

  • You can think for yourself and analyze your data.

Restraint Bias

You underestimate your abilities to resist temptation. Restraint bias is a tendency to overestimate one’s ability. You think that you can control your impulses when you are faced with temptation.

You may find yourself thinking, “I could stop at any moment” or overestimating the temptation you can handle when you feel the urge to trade. Trading can lead to addictive behavior.

Here are some tips to defeat restraint bias

  • Be aware of your triggers when faced with specific situations.
  • Learn how to control impulses

Anchoring Bias

Anchoring bias is when you place too much importance on one piece of information (or the first piece you get) in order to make a decision. This could be the share price or another random benchmark figure. Anchoring bias is when you rely too heavily on a single piece of information as a starting point or reference for your decisions.

Let’s take, for example, the case where you attach your fair value estimation to the purchase price and not the fundamentals of a company. This could lead to holding on investments that are losing value.

How to defeat anchoring bias

  • Your goals and needs will determine your anchor.
  • Make use of objective resources.

Be aware of Irrational and Biased Behavior

One of the most important things we can do as humans is admit that our thinking patterns are not always logical. All of us are victims of our biases, and we all exhibit irrational behavior no matter how rationally-minded we may be.

If we aren’t able to understand our biases when trading and investing, it can be a death sentence for our funds.

Publié at Tue 24 August 2021, 05:23.04 +0000

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