Heuristics are mental shortcuts that humans evolved to possess. We rely on them to make judgments and resolve problems. While heuristics help in a time-sensitive and complex environment, they can also result in suboptimal choices by introducing biases that are fortified through our personal experiences. We often hear of these biases in the context of making investment decisions. In this piece, we identify five common cognitive and emotional biases that can cause investors to lose money in the stock market.
1. Confirmation bias
Cornell Law School defines confirmation bias as the tendency to seek out and give undue credibility to information that supports a desired conclusion. Even though the investment world espouses contrarian thinking and risk management, confirmation bias still persists. Suppose you are a climate change activist and an avid investor. Instinctively, ESG investing calls out to you. With the power of search engines at one’s fingertips, it is easy to find evidence to justify that investing in ESG stocks will lead to higher profits. During the search to confirm a preconceived notion, it can be equally easy to come across antitheses. When confirmation bias seeps in, investors may convince themselves that contradictory information is less reliable, even when it is baked in cold, hard facts.
How to deal with it: Always question your reasoning no matter the level of conviction. Challenge existing assumptions by finding evidence that supports the contrary and avoid sweeping new information under the rug. Another method is to concentrate on your end goal of achieving a stipulated return within selected investment horizons. The aim is to construct a goal-based portfolio that is driven by objective trading rules. Since these goals tend to differ from person to person, doing so reduces the chance of an investor making sudden investment decisions driven by confirmation bias.
2. Overconfidence bias
Overconfidence bias arises due to overestimation of one’s (perceived) skills and acumen. One indicator is undertaking excessive risk because of the tendency to attribute successes to personal skills, and failures to factors beyond one’s control. A closely related bias is hindsight bias where we overstate the likelihood of an outcome when viewing it retrospectively, wrongly thinking that we have the ability to predict certain events. For instance, you may believe that your superior investment shrewdness generated positive returns even if you only rode the bull market up.
How to deal with it: Taking the perspective of other parties can reduce overconfidence bias since we tend to be more objective or critical of others’ decisions. As written documentation aids investors in recollection, penning down the reasons for making each investment is a good way to keep yourself accountable to mitigate hindsight bias.
3. Bandwagon effect
Otherwise known as groupthink, the bandwagon effect refers to a phenomenon where people make decisions to match what the majority believes in. It is arguably the most obvious bias as it is the root of market bubbles. Take the FTX scandal for example: the bankrupt cryptocurrency exchange was backed by many institutional investors. Some of its backers such as Ontario Teachers’ Pension Plan put US$95 million into FTX and insisted that its professionals ‘conduct robust due diligence on all private investments’. Other global names which wrote down their investments include Sequoia Capital, SoftBank, and Tiger Global. Given how established these names are, it begs the question whether some investors placed their trust in FTX by blindly following other respectable peers.
How to deal with it: The FTX example is merely one of many recent fiascos. To avoid the pitfalls of the bandwagon effect, investors must first cultivate the habit of independent thinking. This can be achieved by creating an environment that is least influenced by the opinions of others, such as somewhere quiet. Other methods include slowing down the decision-making process and considering alternative viewpoints through soliciting feedback.
4. Loss aversion
More often than not, people choose to avoid losses over making equivalent gains. Two common scenarios apply in the financial markets. The first is when investors opt for an extremely conservative portfolio despite their goals, risk appetite, and market signals. An example is if an investor held mostly cash between the 2008 Financial Crisis until Covid-19 struck. During this period, federal fund rates were below 2% most of the time, causing the return on cash to be depressed. Contrastingly, holding a well-diversified S&P500 would have yielded over 10% throughout the same period between 2008 to 2020. The second scenario gives rise to the slang term Diamond Hands, referring to investors who refuse to sell regardless of losses. Some may also fall prey to the sunk cost fallacy and put more money into losing positions because existing stakes make abandonment harder.
How to deal with it: Injecting a dose of logic helps counterbalance this emotional bias. Writing down the reasons for each trade frames decisions more objectively. It also makes the investor more aware about what risks are within their control. Setting up impartial rules around buying and selling provides a more systematic approach. Simple tools like market, limit, and stop orders grant investors more control.
5. Anchoring bias
This occurs when investors draw conclusions based on an irrelevant reference point. Any data point such as share prices can be a misleading anchor. A parallel mistake is information bias: evaluation of extraneous information that has no bearing on understanding a problem or decision. For some of us, we obsess over information gathering in a bid to exhaust all methods within our disposal to analyse investment opportunities. Financial columns, the news, and stockbrokers barrage us with heaps of information that has little bearing on medium to long-term prospects. As can be seen, living in an information age can exacerbate certain biases.
How to deal with it: Comprehensively examining all factors can reduce the extent of anchoring bias. However, avoid losing yourself in a sea of facts and figures as doing so leads to information bias. It is important to keep an open mind to incorporate new knowledge whilst filtering out white noise. If one is unsure whether a particular information is relevant, question if it affects the fundamentals that you are analysing and remind yourself that patience often prevails. Managing both anchoring and information bias requires a good balance that can be attained through experience over time.
The fifth perspective
Conquering biases is a crucial aspect of becoming a better investor. The process involves several key steps that, when repeated consistently over time, can lead to improved proficiency in decision-making:
- Recognizing biases: The first step towards conquering biases is to become aware of them. Biases are inherent cognitive shortcuts that can cloud judgment and lead to irrational decision-making. By understanding the various biases that commonly affect investors, such as confirmation bias, recency bias, or anchoring bias, individuals can start recognizing when they are at play in their own thinking.
- Slowing down: Once biases are recognized, it is important to slow down the decision-making process. Slowing down allows individuals to take a step back and critically evaluate their thoughts and potential biases. By creating space between stimuli and response, investors can reduce the impact of impulsive and biased decision-making, giving themselves a better chance of making rational choices.
- Journaling thought processes: Keeping a journal to record thoughts and decision-making processes is an effective way to gain insights and identify biases. Writing down the reasoning behind investment decisions helps individuals reflect on their thinking patterns and identify any biases that may have influenced their choices. Journaling also provides an opportunity for self-reflection and learning from past mistakes.
- Thinking antagonistically: Adopting an antagonistic mindset involves challenging one’s own beliefs and assumptions. Instead of seeking information that confirms existing opinions, individuals deliberately seek out opposing viewpoints and alternative perspectives. By actively engaging with conflicting ideas, investors can reduce the impact of confirmation bias and make more objective decisions.
- Repeat and build proficiency: Conquering biases is not a one-time process but rather a continuous effort. By repeating the steps of recognizing biases, slowing down, journaling thought processes, and thinking antagonistically, individuals can reinforce good habits and gradually build proficiency in overcoming biases. With practice, individuals can become more adept at identifying and mitigating the impact of biases, leading to better investment decision-making over time.
By following these steps consistently, anyone can become a better investor. Overcoming biases is an ongoing journey that requires discipline and self-awareness, but the rewards in terms of improved investment outcomes are well worth the effort.