Become a better investor by overcoming your biases

You will be a better investor if you know you have a bias in your thinking. Accept that fact. And then figure out how to overcome it. This article will help you to do just that.

A bias is like a shortcut your brain takes when it’s trying to understand something. Your brain jumps to a conclusion based on past experiences, personal emotions, or unfair assumptions. It does this because it’s the easiest way to think.

It’s like having a filter that affects how we see things, causing us to favor certain ideas or people without considering everything equally. This can lead to inaccurate judgments or unfair decisions.

Biases can make our thinking less fair and less accurate. And costly!

For example, if you’ve ever had a negative experience with one type of dog, you may have a problem with all dogs of that breed. Even if many individual dogs are quite pleasant. Instead of considering each dog separately, your brain takes a shortcut based on your previous bad experience. That’s a confirmation bias.

Another example is when you’ve seen several news reports about a plane crash, you might start to believe that air travel is dangerous. The vividness of the news reports makes examples of a plane crash readily available in your memory, leading you to overestimate the risk. That’s called availability heuristic. This is when you overestimate the likelihood of something happening because it’s easy to recall examples of it.

There are several types of biases, each with its own method of leading you astray. It’s good to be aware of them, and even better to be prepared to counter your beliefs.

Knowing basic cognitive biases might help you make smarter investment decisions and prevent costly blunders. In short, to become a better investor. I will discuss the most essential biases to keep in mind. Perhaps you’ve already encountered some of these.

The first topic to discuss is confirmation bias. That is the tendency to seek out and interpret information that supports your current beliefs while disregarding or downplaying evidence that contradicts them.

This means you may focus on favorable news pieces and analyst reports that support your viewpoint while conveniently ignoring the warning signs.

This is not about being willfully ignorant. It’s a subliminal process that impacts everyone. It’s a subtle mental habit that can have a big impact on your investment results. Especially if you are unaware of it.

How it hurts your investments

The danger of confirmation bias is that it prevents you from seeing the complete picture. By selectively choosing information, you risk making poor investment decisions based on an incomplete and potentially skewed understanding of the situation. This can lead to:

• Holding onto losing investments for too long: Instead of cutting your losses, you might cling to the hope that the investment will eventually recover, ignoring evidence to the contrary.
• Ignoring red flags: Warning signs about a company’s financial health or market trends might be dismissed because they contradict your pre-existing belief.
• Missing out on better opportunities: Your focus on confirming your existing investment choices might prevent you from exploring other potentially more profitable opportunities.

What to do: fight back to overcome confirmation bias

The good news is that confirmation bias isn’t unbeatable. You can fight back. Here’s how:

1. Seek diverse perspectives: Don’t rely solely on information that supports your viewpoint. Actively seek out opposing opinions and perspectives. Read articles and reports that challenge your assumptions. Talk to other investors with different investment strategies.
2. Challenge your assumptions: Regularly question your own beliefs and assumptions about your investments. Ask yourself: “What evidence contradicts my current view?” “What are the potential downsides?” “What would make me change my mind?”
3. Document your reasoning: Keep a detailed record of your investment decisions, including the rationale behind each choice. This helps you track your thought process and identify any biases that might be influencing your decisions. Review these notes periodically.
4. Use a checklist: Create a checklist of factors to consider before making an investment decision. This helps you avoid emotional decision-making and ensures you’re considering all relevant aspects.
5. Embrace discomfort: It’s uncomfortable to admit you might be wrong. But acknowledging potential flaws in your thinking is crucial for successful investing. Embrace this discomfort as an opportunity for growth and learning.

The next bias I’ll discuss is closely related to this topic.

Have you ever noticed how current events have a disproportionately large influence on your decisions? That is exactly what availability bias is. It happens when we overestimate the value of information that is easily accessible to us because it is recent or vivid.

In the context of investing, this can lead to decisions based only on recent market movements, news headlines, or personal experiences. Instead of conducting proper research, using objective qualitative and quantitative data.

How it hurts your investments

Availability bias can really affect your investing in a negative way. For example it might lead you to:

• Overreact to market swings: If you’ve recently witnessed a market crash, you might be more likely to sell your investments out of fear, even if the long-term outlook remains positive.
• Chase hot stocks: If you hear about a friend who made a fortune on a particular stock, you might be tempted to invest in it yourself, even if it’s a risky or overvalued company.
• Ignore diversification: Availability bias can lead you to focus on a few familiar companies or sectors, neglecting the importance of diversifying your portfolio across different asset classes and industries.

What to do: make more informed investment decisions

So, how can you overcome availability bias? And make more informed investment decisions?

1. Focus on the long term: Remind yourself that market fluctuations are normal and that short-term losses don’t necessarily mean long-term loss. So, don’t sell just because stock prices are dropping.
2. Do your research: Don’t rely solely on anecdotal evidence or recent news. Conduct thorough research before making any investment decisions.
3. Develop a diversified portfolio: Spread your investments across different asset classes and industries to mitigate risk and improve your chances of success.

But wait a minute! Should you just ignore current events because they might have a disproportionate effect on your decisions? No, you should not! Which brings us to the next bias.

We all have a tendency to overestimate the importance of the first piece of information we get, even if it is useless.

This is known as the anchoring bias. It is a cognitive bias in which our initial view of something (the “anchor”) has a strong influence on our subsequent judgments. Even when confronted with data that actually destroys that “anchor”.

How it hurts your investments

Imagine you bought a stock at 100. Even if the market conditions change and the stock’s intrinsic value drops to 80, you might be reluctant to sell. As you’re anchored to the original $100 purchase price.

This behavior leads to holding onto losing investments for too long. And also to missing opportunities to cut your losses and reinvest in something else.

Conversely, if you see a stock initially priced at 200 and it drops to 180, you might perceive it as a bargain, even if the true value is closer to $150. This can lead to buying too high and probably losing money.

Anchoring bias can also affect your investment strategy in other ways:

• Overvaluing initial research: If your first research on a company is positive, you might be less likely to consider negative information later on.
• Misinterpreting market fluctuations: A significant market drop might anchor your perception of future returns, making you overly pessimistic even if the market recovers.
• Ignoring diversification: If your first investment was successful, you might be less inclined to diversify your portfolio, exposing yourself to unnecessary risk.

What to do: take steps to mitigate

While completely eliminating anchoring bias is difficult, you can take steps to mitigate its effects:

1. Actively seek diverse perspectives: Read analyses from multiple sources, talk to financial advisors, and compare your own research with others’ opinions.
2. Focus on fundamentals: Base your investment decisions on objective data such as financial statements, market trends, and company performance rather than emotional attachment to initial price points.
3. Regularly re-evaluate your portfolio: Don’t let your initial investment decisions dictate your long-term strategy. Periodically review your holdings and adjust them based on current market conditions and your financial goals.
4. Use objective valuation methods: Employ tools and techniques to assess the intrinsic value of investments, such as discounted cash flow analysis, to help you make decisions independent of initial price points.
5. Set clear stop-loss orders: Determine beforehand at what point you’ll sell a losing investment to limit potential losses.

By understanding and actively combating anchoring bias, you can make more rational and profitable investment decisions.

Now, let’s explore what happens if you think you’re smart.

We all like to believe we’re quite clever, especially when it comes to our own fields of specialization. I realize I’ve fallen into this trap before. Have you?

However, in the world of investing, that confidence can be a costly trap. It is known as overconfidence bias. It’s not arrogance. Just a small cognitive error that can result in big financial losses.

Overconfidence bias occurs when people overestimate their own abilities and knowledge. This creates a false sense of security and potentially too risky decisions.

In investing, this might lead to:

• Taking on excessive risk: You might believe you can predict market movements better than you actually can. This can lead you to invest in high-risk assets beyond your comfort level or risk tolerance.
• Ignoring expert advice: You might dismiss the advice of financial professionals and believe your own research and intuition are superior.
• Trading too frequently: The belief in your superior ability to time the market might lead to a lot of trading. This means a lot of transaction costs and probably lower returns.
• Underestimating risk: You might underestimate the potential downsides of an investment, focusing only on the potential upside.

How it hurts your investments

The consequences of overconfidence bias can be very costly. It can cause:

• Significant portfolio losses: Risky investments made with overconfidence could wipe out a big part of your portfolio.
• Missed opportunities: Overconfidence can lead you to reject sound advice or promising investment opportunities that don’t align with your overly optimistic expectations.
• Increased stress and anxiety: The roller coaster of emotions associated with risky investments can be incredibly stressful, especially when things don’t go as planned.

What to do to mitigate the effects

Fortunately, you can take steps to mitigate the effects of overconfidence bias. Here are some effective things to do:

1. Embrace humility: Recognize that you don’t know everything. The market is complex and unpredictable, and even the most experienced investors make mistakes. A humble approach allows for continuous learning and adaptation.
2. Seek external validation: Before making significant investment decisions, seek advice from trusted financial advisors or experienced investors. Discuss your investment strategy and get feedback on your approach.
3. Diversify your portfolio: Don’t put all your eggs in one basket. Diversification helps to reduce risk and protect your portfolio from the impact of individual investment failures.
4. Backtest your strategies: If you’re using a particular trading strategy, backtest it using historical data to see how it would have performed in the past. This can help you identify potential flaws and avoid overestimating its effectiveness.
5. Keep a journal: Document your investment decisions, including the rationale behind each choice and the actual results. This helps you track your performance and identify areas where overconfidence might have led to poor decisions. Regularly reviewing your journal can offer valuable insights.
6. Set stop-loss orders: These orders automatically sell your investments when they reach a predetermined price, and so limiting your potential losses. This will help prevent emotional decision-making during market downturns.

As you’ve seen, overconfidence can cause you to lose money. Unfortunately, sometimes you pick the wrong stock. It happens. Let’s find out what can hurt you in such a situation.

I know it sucks, but sometimes you lose money on an investment. Knowing that and how you deal with that knowledge is what loss aversion bias is all about.

Loss aversion is a pretty normal bias almost everyone has. It is the tendency to feel the pain of losses more intensely than the pleasure of equivalent gains

In simple terms, losing money feels worse than the satisfaction of making the same amount. The pain of losing $1,000 is worse than the joy of winning $1,000.

How it hurts your investments

This tendency can lead to poor decision-making when it comes to investing. These poor decisions can really hurt your portfolio:

• Holding onto losing investments for too long: The fear of realizing a loss can cause you to cling to underperforming assets in the hope they’ll recover. This hope often prevents you from cutting your losses and invest instead in more promising opportunities.
• Selling winning investments too early: Conversely, the desire to lock in profits can lead you to selling winning investments too soon. You miss out on potential future gains. The fear of losing those gains outweighs the potential for further growth.
• Avoiding risk altogether: The aversion to loss can lead you to overly conservative investment strategies. In doing so you potentially miss out on higher returns that comes with higher-risk investments. This can hurt your portfolio in the long run.
• Making impulsive decisions: Emotional responses to market fluctuations, driven by loss aversion, can result in rash decisions, such as panic selling during market downturns.

What to do: apply the basics of investing

Loss aversion bias is pretty normal. You are not alone! The way to overcome this one is to follow the basic rules of successful investing:

1. Adept a wealth mindset: Understand that losses are a natural part of investing. Accept the emotional pain of a loss, and try to see it as a learning opportunity. Every investment comes with risk. No portfolio is immune to downturns.
2. Set clear investment goals: Having well-defined financial goals can help you stay focused on the bigger picture. This will help you to avoid making impulsive decisions based on short-term losses. Know your risk tolerance and make investment decisions that align with your long-term objectives.
3. Diversify your portfolio: As said before, diversification helps reduce the impact of individual losses. By spreading your investments across various asset classes, sectors, or regions, you can cushion the impact of market volatility. Avoid putting all your eggs in one basket.
4. Automate and stick to a plan: One way to avoid emotional decision-making is to automate your investments through dollar-cost averaging. This strategy involves investing a fixed amount regularly, regardless of market conditions. It removes emotion from the process and you’re consistently investing over time.

Loss aversion bias is related to two other biases you might have experienced. These two also make you invest money in a losing investment. Let’s find out how that happens and how you can deal with it.

Have you ever kept investing in something just because you’ve already put a lot of money into it? Even if it’s not worth it anymore. If you have, you’ve fallen to the sunk cost fallacy.

You might’ve thought, “I’ve come this far, I can’t quit now!” But that’s exactly when this cognitive bias messes with your portfolio.

It’s one of the most common biases out there. You don’t want to feel like all your hard work was for nothing, even if it’s not worth sticking with.

How it hurts your investments

The sunk cost fallacy is a trap that might lead you to hold on to losing assets for way too long. If you’ve already put a lot of money in a particular stock, you may not like to sell it. Even when you know the stock will probably never recover again.

This attachment can interfere with your judgment and prevent you from making decisions based on your financial plan.

Imagine you bought a stock at $50 and it’s now at $25. You’re down $25 per share. This might be a good time to sell. Instead you think it will get back to $50, and you buy some more.

You’re not considering the current situation. The stock might be fundamentally flawed. You’re letting your initial investment cloud your judgment. In reality that initial $50 is now a sunk cost. It’s gone. The only thing that matters now is the future potential of the stock. Which is probably very low!

What to do: separate emotions from decisions

This one is simple to overcome. Just sometimes not that easy. The key is to separate your emotions from your investment decisions. Base your decisions on future potential, not past commitments. Ask yourself these questions and the answer will guide you in the right direction:

1. Ignoring the past, is this still a good investment? Would I buy this stock today, knowing what I know now? If not, is now the right time to cut my losses?
2. What’s the opportunity cost? By holding onto this losing investment, what other opportunities am I missing?
3. What’s my risk tolerance? Can I afford to lose more money?

Don’t let pride or the weight of past decisions dictate your future investment choices. Act objective and rational. Keep in mind that sometimes the best investment is to cut your losses and move on.

The next bias also kicks in just because you already invested in something.

Have you ever struggled to sell a stock or investment you own? Even when it’s obvious it’s not working well?

If so, you may have encountered what is known as the endowment effect.

The endowment effect means you believe something is more valuable just because you own it. You overvalue stocks you already own simply because you own them.

How it hurts your investments

The endowment effect makes you irrationally attached to your investments. You hold onto assets for longer than necessary just because they are already in your portfolio. It’s that feeling where you’re reluctant to sell a stock, even if it’s underperforming, because you’ve owned it for a while and it feels like your asset.

This feeling can lead you to holding onto losing investments. You might cling to a stock that’s dropping in value, hoping it will recover.

You will then also miss out on better opportunities. You’re emotionally attached to your current holdings, and may be less likely to invest in other stocks. Your portfolio becomes stagnant.

What to do to become a better investor

You can overcome the endowment effect. The first step is recognizing that you might be emotionally attached to your investments. The next step is to approach your investments objectively. Like if you were evaluating them for the first time. It’s natural to feel a sense of ownership, but being aware of this can help you make more objective decisions. Think about these actions:

1. Regular portfolio reviews: Examine each investment independently, as if you were a stranger evaluating its potential. Ask yourself: “Would I buy this today, knowing what I know now?”
2. Focus on the numbers, not the feelings: Don’t let sentimental attachment cloud your judgment. Analyze the financial performance of each investment, regardless of how long you’ve held it.
3. Consider opportunity cost: Ask yourself: “What could I achieve with this money if I invested it elsewhere?” This helps you to see the potential gains you’re missing by holding onto underperforming assets.
4. Rebalance your portfolio: Regularly rebalance your portfolio to maintain your desired asset allocation. This might involve selling some assets you’re emotionally attached to, but it’s a crucial step in optimizing your investment strategy.

When you’re busy with the above mentioned actions you might be affected by the next three biases.

The herd mentality (also known as the bandwagon effect) is a powerful psychological bias that drives you to align with the views and practices of the majority, even if they contradict your own judgment. It’s like following the crowd without doing your research. You have probably done this once or twice. I know I have.

How it hurts your investments

If this leads you to make impulsive decisions based on what others are doing, you may be making the wrong decisions. Others may be wrong. You may just be following the crowd.

If you follow the crowd in investing, you will be swept up in market trends. You will buy stocks during a rally or sell during a downturn simply because others are doing so. You will be caught up in market bubbles and panic selling. In the end, you will have bought high and sold low. Exactly the opposite of what makes the most sense.

While it may feel comforting to be part of the crowd, the herd mentality often leads to poor timing. This behavior can cause you to miss long-term opportunities. Or it will lock you into unnecessary losses. Certainly, it will increase your overall portfolio risk.

What to do

The most important thing is to stand on your own two feet. You can (and should) look at what the crowd is doing. But you should not follow blindly. Do your own independent thinking and follow a disciplined investment approach. In short, this means:

1. Stick to your investment plan: Having a clear, long-term investment strategy helps you stay focused on your goals. A disciplined approach can keep you grounded, especially when the market is buzzing with excitement or fear.
2. Do your own research: Instead of blindly following what others are doing, take the time to evaluate investments based on your own analysis. Look at fundamentals, financial reports, and trends. Ask yourself if an investment fits within your plan.
3. Resist the urge to chase trends: The fear of missing out (FOMO) can be powerful. But chasing after the latest market trends or “hot stocks” often leads to buying at inflated prices. Resist the temptation to jump into something just because it’s popular.
4. Focus on long-term goals: Remember that investing is about building wealth over time. Don’t let short-term noise or market hype distract you from your long-term objectives.
5. Develop your own investment strategy: Create a long-term investment plan based on your own risk tolerance and financial goals. Reacting to market trends or popular opinions is not a strategy.
6. Ignore the noise: Tune out the hype and focus on your investment strategy. Don’t let fear of missing out or pressure from others influence your decisions.

The next bias is related to herd mentality. As the next one is also about making a decision based on the wrong idea.

Recency bias is a cognitive bias in which you give too much weight to recent experiences or information when making decisions.

In the world of investing, this means that you overreact to short-term market trends. You make decisions based on what’s happening right now. In the process, you forget to consider the long-term outlook and historical trends.

How it hurts your investments

Recency bias leads investors to become overly enthusiastic after a market rally or overly pessimistic after a bad day or week.

For example, after a period of excellent market performance, you may be tempted to invest heavily in the belief that the positive trend will continue indefinitely. Conversely, after a market crash or just a bad couple of days, you may withdraw your investments. You fear that the worst is yet to come.

This reactive approach often results in buying high and selling low. These are two of the most costly mistakes investors make.

Do not let recent events cloud your judgment. Make decisions that are consistent with your long-term financial goals.

What actions to take

As this one is closely related to the previous bias, it’s no surprise that the actions you can take to overcome recency bias are quite similar. In short that means:

• Focus on your long-term goals
• Diversify your portfolio
• Avoid emotional reactions (as much as possible, as you are still a human)
• Review historical data
• Stay disciplined with your investment plan

As long as you understand recency bias and you stay focused on your long-term goals, you will avoid making impulsive investment decisions.

The last one I will discus in this article has to do with the place you live.

Home bias is the tendency for investors to favor home assets in their portfolios, even if foreign diversification could yield greater risk-adjusted returns.

It’s a comfy and simple bias. We are familiar with our native country’s businesses and economies. The rest? Not so much.

How it hurts your investments

Home bias makes you more likely to lose money. You are exposing your portfolio to just one country, one economy. Therefore your portfolio will have:

• Reduced diversification: Concentrating investments within a single country exposes your portfolio to the unique risks of that country’s economy. A downturn in your home country will significantly impact your returns.
• Missed opportunities: Focusing solely on domestic assets means missing out on potentially higher returns available in other, more dynamic markets.
• Higher risk: Lack of diversification increases the volatility of your portfolio. You’re essentially betting everything on the success of your home country’s economy.
• Currency risk: While international diversification introduces currency risk, home bias leaves you completely exposed to your home currency’s fluctuations. A weakening home currency can reduce the value of your investments.

What to do

Global diversification is a key element of long-term investment success. So by overcoming home bias, you can reduce risk, improve returns, and build a great portfolio. To mitigate the negative effects of home bias, consider these strategies:

1. Diversify geographically: Spread your investments across multiple countries and regions to reduce your dependence on any single economy.
2. Invest in international index funds: These funds offer easy and cost-effective access to a broad range of international stocks, providing instant diversification.
3. Research global markets: Learn about different economies and their investment opportunities. This will help you make informed decisions about international investments.
4. Consider emerging markets: Emerging markets often offer higher growth potential than developed markets, but they also carry higher risk. Carefully assess your risk tolerance before investing.
5. Rebalance your portfolio: Regularly rebalance your portfolio to ensure it aligns with your desired asset allocation, correcting any drift towards over-concentration in domestic assets.
6. Consider ETFs and mutual funds: If you’re unsure about selecting individual international stocks, consider using global ETFs or mutual funds. These funds allow you to invest in a broad range of global assets, making it easier to access international markets without having to pick individual stocks yourself.

Understanding cognitive biases is the first step towards overcoming them. This could have a significant impact on your decision-making. Recognizing your brain’s shortcuts allows you to pause, ponder, and make more informed decisions.

Whether you’re investing, creating views about others, or simply navigating your day, being aware of these mental filters allows you to think critically and prevent costly mistakes.

Keep in mind that prejudices are a normal aspect of being human. They do not define or govern us. With practice and the correct perspective, you can challenge your assumptions.

Continue to be interested and examine your thoughts. You’re already on the right track simply by reading this! 😄

Thank you so much for your attention!