“I thought that I’d made an intelligent choice; why am I still not reaping the rewards?”
Unfortunately, despite the general belief that we are rational in our decisions and risk-averse enough to prevent chalking up investment losses, human cognition can never be 100% predicted! Sometimes, we simply act in an illogical manner without even realising it and we end up being confused as to why stock prices change in anomalous ways. If we were that predictable, there would be no need for any sort of speculation in the first place. So, what are some financial biases that we could be committing right now?
Here is a quick look at 3 common ones:
1. Anchoring bias
Anchoring bias is a cognitive shortcut that we experience daily, and not just in investments. Imagine that you want to buy a new pair of shoes: after some research online, you find out that this particular model retails at an average of $200. When you go to the mall, you see a store selling the shoe at $120 and you accept the offer because why not? It’s much cheaper than what I found online! However, after walking round the mall, you realised that another store is selling the exact same shoe at only $60! You’ve found yourself a victim of the anchoring bias: favouring the pre-existing piece of information that we have and making hasty, seemingly illogical decisions. In the case of these shoes, the $80 discount seemed like a great deal when compared against the ‘base price’ of $200, making us neglect the possibility of another store carrying it at an even cheaper price.
Similarly, when we invest, the anchoring biases can cause us to buy an overvalued asset. Sometimes, we may also end up holding onto investments that have lost their value. Typically, investors show anchoring biases when they fixate on the price at which they’ve bought a stock and expect future performance to exactly replicate past performance. Alternatively, past experiences of losses could also bias investors towards permanent pessimism for certain investments, ignoring any logical arguments.
To become a savvy investor, make decisions that target this bias: always apply the appropriate investing framework and system to form your investment thesis and decisions. Do not make a decision based on a single piece of past evidence and ignore present analyses.
2. Hindsight bias
Also known as the knew-it-all-along phenomenon, hindsight bias describes our innate need to make causal links in the world that are inherently predictable. Perhaps you may have bought a single stock at a low price, being wary of its growth-potential. After a while, the stock doubles in price and you say “I knew it would grow!”; yet, there was no way for you to 100% predict the appreciation of your investments. If it was so predictable, wouldn’t you have bought more shares of that company?
Hindsight bias is dangerous for a few reasons. It makes us believe that we have top-tier stock-picking abilities, even though our initial buy was based on speculation. Also, such an erroneous link between our decision and its outcome gives us overconfidence in our investment strategies. If we neglect the existence of hindsight bias, we may falsely stick to these poor strategies and make poor decisions in the future.
While hindsight bias may be tough to eradicate, we can try to actively remind ourselves that we can’t predict the future! Especially in the context of the investment market, blind predictions are impossible and do not bode well. Instead, we can only make educated and supported guesses based on the investing rules such as applying fundamental analysis and technical analysis to form our investment thesis.
3. Gambler’s fallacy
The Gambler’s fallacy, as its name suggests, describes erroneous beliefs that we may have with regards to probability outcomes. Say, for example, you play a game of heads-or-tails — the coin has landed on heads four consecutive times. If asked to predict the next outcome, most would say that tails should appear next, because heads have already appeared so many times. However, the probability of heads as an outcome and tails as an outcome is identical and independent of each other! Yet, we have a cognitive belief that if a particular event has been occurring more frequently than normal, it is less likely to happen in the future and vice versa.
Similarly, gambler’s fallacy is observed in the behaviour of many investors! Investors may act in ways similar to the heads-or-tails example: investors buy an investment that they believe to rise in value because the investment has been showing movement in the opposite direction over consecutive trading sessions.
Instead of predicting the price is set to rise because it has been falling for some time, apply statistics-driven technical analysis to read the charts and general sentiments of the markets. In addition, if the fundamentals of a company are poor, the price can possibly continue to fall on a downtrend with no rebound ahead. Apply the investing rules rather than to gamble on the next possible outcome.
By understanding some of the common biases that we investors may be vulnerable to, we can potentially tweak our investment strategies for the better and reach our investment goals faster!
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