Cognitive and Emotional Biases Among Investors
Every investor has biases and sometimes it’s difficult to overcome them to be rational and logical investor. The first step is to know what these cognitive and emotional biases are and see if we have them in ourselves.
Cognitive Bias
You can consider or think of cognitive bias as a rule of thumb that may or may not be based on facts. Here are some of the examples of cognitive bias.
Confirmation Bias
Confirmation bias may be clearly represented by the tendency to put more weight on the opinions of the people who agree with you. Investors are also guilty of this. To avoid this, it’s wise not to just research reports or facts that support your decision but also search those that contradict or may poke holes in your argument.
Gambler’s Fallacy
For example, the S&P 500 rallied for 4 consecutive times. You decide to short the index because you believe that the 5th session will see it go down.
This is possible on a purely statistical basis. However, past events don’t necessarily connect to future events. There may be other reasons why the index may fall down on the 6th session, but the index rising up four times previously is essentially irrelevant.
Status Quo
It is very natural for humans to develop habits. Resistance to change also manifests in investment portfolios via the act of repeatedly coming back to the same stocks and exchange-traded funds rather than researching new ideas.
Even though investing in the companies that you understand is a good and sound investment strategy, having a list of go-to products may certainly put a cap to your profit potential.
Negativity Bias
There are investors who miss rallies even in a great bull market because of fears that the bear will hit them. Negativity bias pushes investors to put more weight on bad news than on the good ones.
There are those who consider this as risk management. However, this bias can cause the effects of risks to hold more weight than the chances of achieving a huge reward.
Bandwagon Effect
Avoiding the bandwagon effect is one of Warren Buffett’s key strategies that helped him succeed and become one legendary investor.
According to him, it helps when an investor is greedy when others are fearful and fearful when others are greedy.
As with confirmation bias, investors usually feel better when they invest with the flow of the crowd. However, Buffett proves that having the opposite mentality when research has been done is more rewarding.
Emotional Bias
Emotional bias, in a nutshell, is taking actions based on feelings instead of facts. Emotional biases lie deep in the psychology of investors and they are generally more difficult to beat.
Loss-Aversion
This bias is seen when, for instance, you don’t want to admit that the loss has gone from a computer to real money.
Overconfidence
An investor who has an overconfidence bias believes that his/her skills are better than others’ skills.
Endowment
Similar to loss aversion, the idea lies in what we don’t instead of what we don’t. Other sectors may show signs of robustness, but an investor with endowment bias won’t sell because he/she believes that the sector he/she is in is the best sector.
