When investors chat, a common topic revolves around which stocks have been purchased or sold.
What is seldom discussed, but is no less important, are emotional biases that could negatively impact a carefully-constructed portfolio and cause investors to lose money.
If left unchecked, these biases could wreak havoc on your investment process, causing you to lose significant sums of money.
We look at three common emotional biases that could trip you up.
Hindsight bias
The first bias is known as hindsight bias and is so prevalent that even seasoned investors are affected by it.
Hindsight bias refers to investors who knew how an event turned out but are fooled into thinking that they knew the outcome all along.
This is despite high uncertainty as to how things will turn out.
A good example is the Global Financial Crisis of 2008-2009.
Many investors claim that they knew Lehman Brothers would go bankrupt while Citigroup would be saved by the US Government.
The flaw in this logic is clear – people say this with certainty because they already know the outcome of these two events.
It is not because they had some magic crystal ball that informed them of how events will transpire at the time.
The best way to avoid this bias is to pen down all investment decisions made.
By doing so, you can check back on your thought process and avoid assuming that you could reliably predict how numerous uncertain events will pan out.
Confirmation bias
The second bias is confirmation bias.
This bias makes you actively seek out facts or information that conform to your beliefs, and ignore or discard information which does not.
Do you see why doing so can be so dangerous to your investment process?
It is because it blinds you to alternative points of view that may invalidate your original investment thesis.
These divergent views may be the key determinant between a successful investment versus a loss-making one.
Hence, it is very important to seek out contrary views to learn and grow as an investor.
Endowment effect
A third bias to be wary of is the endowment effect.
This effect makes you feel as though the shares you own are somehow more valuable than those you do not own.
Hence, you start to demand a higher price for shares you own as these shares are perceived to be more valuable, even if reality may suggest otherwise.
If you are struck by the endowment effect, then a failing business could still seem attractive to you purely because you own its shares and have a vested interest.
For shares that you may not own, you may assign a low value to them even though the business may be an excellent one, thereby preventing you from buying shares that will benefit your portfolio.
Get Smart: Always question yourself
The three biases above may be pervasive, but you can get around them if you constantly question your investment decisions and attempt to see different viewpoints.
Remember not to try second-guessing what will happen as the world is too uncertain for us to know for sure.
Finally, it is recommended that you adopt a logical and rational approach to valuing companies rather than assigning a higher value to them just because you are a shareholder.
By keeping your mind alert to the emotional biases above, you will end up being a much Smarter Investor.
This could be the fastest way to jump from a “newbie” investor to a seasoned pro. Our beginner’s guide shows everything you need to know to buy your first stock and beyond. Click here to download it for free today.
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Disclosure: Royston Yang does not own any of the companies mentioned.
