Investing your money allows you to slowly grow your wealth over time to better prepare yourself for retirement.
Tying your money up in the stock market can be an emotional affair, though.
With money involved, you can cycle through a whole range of emotions from greed to fear as stock prices gyrate.
Aside from the two emotions above, you will be bombarded by a host of other psychological biases and fallacies that could negatively affect your investment process.
We highlight five of these that could trip you up and how you should be wary of them.
1. Home Bias
Many investors prefer to stick with investments within their country as such businesses are familiar to them.
This phenomenon is known as home bias.
Investors who are afflicted with home bias tend to choose investments in their home country as they feel more confident and secure about the business.
Doing so, however, may be bad for your overall investment results.
With a wide universe of stocks out in the world, limiting yourself to investments within your home country means you also limit your exposure to other promising businesses.
For instance, a Singaporean may choose to invest only in Singapore-listed stocks.
This action excludes opportunities that can be found on other stock exchanges such as the US, Europe, and Hong Kong.
The way to counteract home bias is to keep an open mind about your investments and try to include a healthy mix of international and local companies.
2. Gambler’s Fallacy
Gambler’s fallacy occurs when a person believes that a random event is more or less likely to happen because of a previous random event.
Like the gamblers found in casinos, this fallacy stems from a belief that seemingly random events are somehow linked and have a bearing on the outcome of the next random event.
A good example is the roulette wheel where the outcome is red eight times in a row.
Although there is a 50-50 chance of the ball landing on a red or black square, gamblers somehow believe that the next roll should be black because the ball has landed on red eight times without fail.
The same thing happens in investing, too.
A stock which has risen over many consecutive days may lead the investor to believe that it is poised for a fall.
However, if the business is buoyed by good news or a positive event, then share prices can head upward without a pause.
Believing in the gambler’s fallacy may cause investors to prematurely sell a winning stock.
3. Recency Bias
Recency bias draws investors’ attention to an event that happened recently that remains fresh in their minds.
Doing so, however, causes investors to neglect more pertinent information that may have a bigger impact on their investment decision-making process.
The ease of recall of a recent event may also lead investors to put greater weight on its probability of occurring again, even though the event may not be a common one in the first place.
An example is the sharp crash in share prices at the onset of the Global Financial Crisis when Lehman Brothers went bust.
Recency bias may cause investors to hold back from investing for fear that a similar crash could occur.
In the long term, such events end up being extremely rare and investors should consider information such as how businesses can pick themselves up after the economic crisis.
Such considerations are more important than the occurrence of a single major event.
4. Base Rate Neglect
Base rate neglect involves investors who wrongly judge the likelihood of an event by not considering all relevant data.
Investors tend to give more weight to event-specific information about a company than consider the long-term growth trajectory of the business.
A weak quarterly earnings report may not be sufficient to derail the company’s long-term growth initiatives.
However, an investor who suffers from base rate neglect may see this event as changing the trajectory of the business and sell his shares in a hurry.
The weak quarter may turn out to be just a blip for the business which then goes on to grow at above-average rates, causing its share price to continue its upward climb.
Investors end up missing out on such stocks if they do not consider base rate assumptions about the quality of the business.
5. Herding Behaviour
Herding refers to social behaviour that causes a group of like-minded people to perform the same action.
Such herding can be detrimental to your wealth when applied to investing.
By following the crowd in chasing hot stocks, you may inadvertently be buying an overvalued company that is poised for a sharp fall.
Herding also causes a group of investors to overweight certain stocks or sectors because of hot tips or rumours.
Such behaviour may draw in other investors who believe in the hype, thus causing them to lose big when everyone heads for the next big thing.
Disclosure: Royston Yang does not own shares in any of the companies mentioned.
