Previously, we looked at three psychological biases that investors should be wary of.
These biases sub-consciously affect how we perceive and deal with our investments.
Any activity involving money is unavoidably emotional and this is not surprising as money is viewed as a valuable commodity that everyone wants more of.
To add to the first three biases, here are three more biases that may interfere with your investment process.
Anchoring bias describes how our minds “anchor” to a point of reference in the absence of convenient or available information.
For example, you may have purchased a souvenir for S$5.
When you come across a similar-looking souvenir, your mind will “assign” a value of S$5 to it even though it may be made of a different material or have a more intricate design.
This is a simple example of anchoring.
When applied to investing, it refers to an investor who “anchors” to his buy price and cannot bring himself to buy at a price higher than his original purchase.
This mental anchor gets in the way of sensible investing.
By right, this investor should be looking at the valuation of the company and its prospects, rather than benchmarking the share price to his original purchase price.
The way to overcome this bias is to treat each purchase as a separate transaction and evaluate it independently.
The next bias is over-reaction bias.
As the name suggests, this bias refers to the tendency for people to overreact to negative events.
Stock markets generally tend to move up slowly over time, while crashes occur with much fanfare and are more rapid.
Why does this occur with regularity?
It is because people tend to feel optimistic and buy slowly, allowing share prices to rise steadily.
But when bad news arrives, it is magnified and the emotional response treats it as something more serious than it should be.
Sharp and sudden selling that lead to plunging share prices.
To be fair, this response is tied to our primitive brain mechanism which emphasizes a “fight or flight” response to danger.
In the early days when humans were hunters, an overreaction to potential danger would have saved our ancestors from being eaten by predators.
But in modern times, this reaction will end up being detrimental to your financial health.
Yet another bias relates to overconfidence.
This trait is arguably more common than we care to admit.
You may be surprised to know that 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.
The results were shocking, to say the least.
93% of American drivers claimed to be better than the average, which is statistically impossible.
When investing, you may tend to over-rate your ability in picking winning stocks.
When this happens, you become blind to errors or deficiencies in logic.
To provide an extreme example, imagine an investor who parks a large chunk of his portfolio in an unprofitable company, in the belief that it will turn around very soon.
Unfortunately, the company goes bankrupt and the investor loses everything.
This investor suffered from over-confidence in his abilities and failed to adequately diversify or consider the risks involved.
If you enjoyed reading the above, then watch this space for more psychological biases in subsequent weeks!
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Disclosure: Royston Yang does not own any of the companies mentioned.