Most of us believe ourselves to be rational creatures who are fully capable of making sound decisions in life. A behavioral psychologist, on the other hand, would quickly disagree.
Psychological research throughout the years has shown that humans are deeply biased creatures. That’s not really a weakness. Our brains are programmed to function in a certain way to increase our chances of survival. However, thesethat served to be so useful in the jungle have proved to be quite disastrous when it comes to modern life choices, particularly financial decisions.
If you are an investor or hope to become one, innate biases should certainly concern you. If you are inclined to think in a particular way, such as being quick to agree with others around you, you may be making biased, but it isn’t always so cut and dry.
Representative bias occurs when investors determine the value of stocks based on their most recent performance. This bias usually leads investors to ignore when stock values perform badly. This hinders your ability to determine the real value of a security or a share. You may ignore a group of penny stocks that might have recently performed badly but have historically been rising in value due to this type of bias.
You purchase a stock believing it to be of high value. But once the sale is made, you realize that the assets are less than what you thought they were initially worth. Instead of accepting that you have made a bad decision, you end up making excuses. This is regret aversion.
Investors who succumb to regret aversion hold on to losing stocks and fail to cut losses on time. They may also be unwilling to take on more risks for higher rewards. Obviously, regret aversion does not bode well on an investment portfolio in the long run.
Doing What Everyone Else is Doing
Do you only invest in sectors or stocks that everyone you know does too? This is the herd mentality, known as the bandwagon effect in the financial world. It essentially refers to investors who are only comfortable investing with the rest of the crowd. This method can go seriously wrong. Warren Buffet famously advocated against the bandwagon effect, as his enormous success shows.
There are too many biases that prevent investors from succeeding as they should. To overcome these biases, learn to invest with a plan in place. Learn to do your research and be keenly aware of the biases you could fall victim to. Only then will you develop a sound investment portfolio.