6 Psychological Biases To Watch Out For When You Are Investing
Anything involving money has been shown to elicit an emotional response, and perhaps this is not surprising as money is viewed as a scarce resource and valuable commodity which everyone wants more of!
A previous article of mine covered three psychological biases which investors should be wary of, as these biases would sub-consciously affect how we perceive and deal with our investments. They are the hindsight bias, confirmation bias, and endowment effect.
In this article, I want to discuss three more biases to watch out for which may have a pervasive effect on investing.
The first is anchoring bias, which is how our minds “anchor” to a point of reference in the absence of convenient, available information. For example, we may have purchased a souvenir for $5, and when we come across another similar-looking souvenir, our mind would tend to “assign” a value of $5 to it even though it may be made of a different material, or have a more intricate design.
When applied to the realm of investing, the anchoring bias refers to an investor who “anchors” to his purchase price and cannot bring himself to buy at a price higher than his original purchase, or sell at a lower price. This gets in the way of sensible investing as we should be looking at the valuation of a company versus its prospects, rather than benchmarking its share price to our original purchase price. The way to overcome this bias is to treat each purchase or sale as a separate transaction and evaluate them independently.
The next bias is termed the “over-reaction bias”, and as the name would suggest, it refers to the tendency for people to over-react to negative events. Stock markets generally tend to move up slowly over time, while crashes occur with much fanfare and are much more rapid. This is because people tend to feel optimistic and sanguine in a gradual manner, leading to share prices rising slowly and steadily. When bad news arrives, the emotional response would be to magnify the news and treat it as something more serious than it should be, hence resulting in sharp and sudden selling, causing share prices to plunge rapidly.
To be fair, the over-reaction response is tied to the more primitive portion of our brain mechanism which emphasizes a “fight or flight” response to danger – in the early days of hunting, an over-reaction to potential danger would have saved our ancestors from being eaten by predators. In modern times though, this reaction would be detrimental to your financial health.
The over-confidence bias is the third bias, and relates to how most people are over-confident in their ability to perform a physical or mental task. A prime example of this was a survey which questioned if people were above-average drivers – 93% of American drivers claimed to be better than average!
For investing, many people have a tendency to over-rate their ability to pick winning stocks, and this blinds them to errors they might make, or deficiencies in logic which they may possess. An extreme example of this might be an investor who puts a large chunk of his capital into a company, believing that it would turn-around very soon, only to lose it all when the company goes bankrupt. This investor suffered from over-confidence in his abilities and failed to consider the myriad risks involved.
Watch out for more psychological biases which I will cover in subsequent articles.