Previously, I had written about six different biases that can affect your investment process and impair your ability to make good decisions.
Aside from biases, there are also two categories of psychological influences which can impair judgement and wreak havoc on your investment process.
These influences are divided into two groups – fallacies and illusions.
Illusions are a distortion of the senses and they warp our perception of reality.
Let’s take a look at three types of illusions that you need to be wary of.
Illusion of control
When it comes to money matters and investing, the illusion of control seems to manifest itself fairly often.
This illusion makes people overestimate their ability to control events or outcomes.
Investing is a probabilistic exercise where investors need to rely on insights and rigorous analysis to come up with conclusions to support their investment theses.
You must focus on refining your investment process rather than fixating on the outcomes.
Investors suffering from the illusion of control may feel that they can control the outcomes of their investment decisions when in reality, there are myriad factors, including luck, at play.
This illusion may cause the investor to feel over-confident and plough too much money into an investment idea, with the erroneous assumption that the outcome can be determined.
Jumping to conclusions
Jumping to conclusions occurs when you believe that you possess superior knowledge.
This belief makes you take shortcuts when making decisions.
There is a tendency to rely too much on information that was obtained through hard work and effort, leading to confirmation bias.
Armed with what you believe is “superior” knowledge, you end up letting your guard down and making hasty, ill-timed investment decisions.
Remember that bad investment decisions can end up costing you an arm and a leg, and are something you will regret later in life.
Clustering illusion is the belief in the existence of patterns where none exist.
This phenomenon is commonly found among chart readers (i.e. technical analysts) who claim that they can identify patterns within lines and squiggles.
The brain is an amazing organ in its complexity and frequently plays tricks on us by allowing us to “see” patterns among seemingly random and unrelated phenomena.
As a simple example, think of how you can somehow see familiar faces or shapes when you look at clouds floating in the sky.
Yet, everyone knows that cloud movements are completely random.
From these two examples, you get an idea of how prevalent this illusion is.
Focus on how the business is doing and ignore the cute squiggles and historical charts.
How a business will perform in the future is the best predictor of where its share price will head.
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Disclosure: Royston Yang does not own any of the companies mentioned.