5 Behavioral Biases You Should Be Aware Of Now by Alexander Wetterling, Become A Better Investor
When the markets seem a bit more uncertain than usual, and you are bombarded on all sides with cascades of information—whether it’s negative, positive or conflicting news—about what’s going to happen next; it is important to trust yourself and your own judgment. To achieve this means that you must know yourself; as Benjamin Graham said, “The investor’s chief problem—and even his worst enemy—is likely to be himself.”
I don’t think it’s overly controversial to say that the markets around the world have been volatile since the “Chinese stock rout” started in June last year, and oil prices began to fall from $60/bbl in July just after, to hover around $30/bbl year to date. Ever since, investor sentiment has turned more bearish; as shown in numerous surveys, on the news, and in Andrew’s personal twitter poll recently.
If you had cash today would you buy stocks with it?
— Dr.Andrew Stotz, CFA (@Andrew_Stotz) February 24, 2016
I won’t try to predict the future of the market in this post, but instead, I will focus on the 5 behavioral biases you should be aware of that you, and every investor, most likely suffer from. At many times in our lives—and especially in investing—we are our own worst enemies. But, awareness and admittance can help you out in times like this, in order to make better investment decisions.
Despite whether we want to admit it or not, we are emotional creatures and as such, our emotions affect our behavior and decision making. Furthermore, research has proven that we each have our own set of heuristics (those ‘rules of thumb’ we follow) that are either learned or hard-wired into our brains or genes according to neuroscience and evolutionary psychology.
As you will notice behavioral biases don’t usually show themselves in isolation but feed off each other or become a combination of many that lead you to act the way you do. Listed below are the 5 behavioral biases that we all suffer from and how you can deal with them.
Anchoring is when we fixate on some past information and then base our future investment decisions on this. One way is to anchor to the price you bought a stock for, and another to anchor to the price target you expect it to achieve (based on your valuation and expectations) and then stick to your anchor even when new information suggests you should do otherwise. The world around us changes, and so do the fundamentals of the company you have invested in; there are all sorts of information that can affect its share price.
By just being aware of your anchor and that it can become irrelevant due to new information, you should be able to deal with this bias.
Confirmation bias is the tendency to search for, focus and put weight on information that confirms beliefs you have already. You purchase a stock because you spent a month researching the company and think the business has great growth potential and a revolutionizing product.
You then seek to reinforce and confirm this belief by reading and allowing any company announcements and news to add weight and support your point of view. You may also actively choose to ignore news about a possible competitor launching something that will make your investment company’s product obsolete.
Always be open to opposing views and strive for objectivity. Play devil’s advocate with yourself or ask a friend to challenge your opinion.
Recency bias is the way in which we overweight future decisions based on recent events and information. With the market in a downward trend now, as it has been for some time, we tend to assume that it will continue to go down—and vice versa in the alternative of that situation.
Again, increasing your awareness of recency bias will help you to deal with it. Be sure to put everything in a larger perspective and expand your time horizon when making decisions about your investments. See the bigger picture.
Herding is displayed when we decide to follow the crowd—being the social animals we are—rather than acting contrarian and running by ourselves—not with the herd. Keynes said, “…it is better for reputation to fail conventionally than to succeed unconventionally.” This one is a bit tricky as you can indeed make money by following trends, and so too you can lose money by going against the crowd.
Herding behavior by others can make you doubt your contrarian view or force you out of your contrarian position. Financial and economic bubbles have shown throughout history though that the herd can run in the wrong direction for a long time, so being a contrarian will require strength and stamina—but it can be profitable too.
My advice here would be to seek information and then create an informed opinion and to always have a rationale for your investment decision. Don’t just do it because everyone else is.
There are a wealth of academic papers, books, articles, blog posts, speeches—this could go on forever—already out there about overconfidence, so I will keep it short: YOU ARE OVERCONFIDENT.
This may come across as an overconfident statement to make, but it’s highly likely that you are, and even if you aren’t you will learn from this. Admit that you are overconfident, be humble, do your research, and at least, know that you don’t know it all.
I recommend that you spend time getting to know yourself better, and learn to not be your own worst enemy. Be aware of your flaws; whatever they may be and for whatever reason you have them.
Be humble and admit your shortcomings; that you don’t know it all and are not always right. Keep on learning and strive to Become a Better Investor each day and soon, you will!