In order to achieve success in investing you must make good investment decisions and act on them. However, as investors we are all prone to psychological or behavioural biases that can lead to poor decision making and investment mistakes. 

When facing uncertainty together with a large amount of information that needs to be processed, we may not have the time or ability to arrive at the best decision. As a result, we will tend to over simplify complex decisions, take mental short cuts, and at times become overconfident in our decision-making process. This leads unintentionally, to biasing our investment decision making. By being aware and understanding our biases we can significantly improve our investment outcomes. Below we list the eight psychological biases that we believe you should strive to eliminate from your investment decision making.

1. Confirmation Bias

Confirmation bias relates to paying more attention to evidence that supports our opinion while ignoring evidence that disqualifies our conclusions. We will often resort to preconceived opinions when encountering new things or people. As investors, this means we are more likely to look at information that supports our investment thesis rather than seek out information which contradicts our views.

2. Loss Aversion Bias

Loss aversion refers to the tendency that people tend to feel the pain of a loss more than the pleasure they feel from a gain. Some studies have shown that psychologically losses are twice as powerful as gains. Loss aversion causes investors to not want to sell their loss-making investments as they hope that they will recover their losses. By refusing to sell losing positions investors also increase their opportunity cost as they miss out on superior investments, and opportunities they could have capitalized on had they sold their underperforming positions.

3. Hindsight Bias

Hindsight bias is the perception that investors believe after the fact, that a specific event or outcome was predictable when in fact the event could not have been predicted. Hindsight bias is dangerous for investors as it clouds the mind when accessing past investment decisions, and as a result stops investor’s learning from their past mistakes.

4. Familiarity Bias

Familiarity bias occurs when investors prefer familiar investments despite their being better investment options available. Investors may prefer to purchase a particular stock because they know the brand or product which can make the investment feel easier or less risky. Familiarity bias can mean that great investments can be missed simply because an investor is not familiar with a company. Using an analogy, it is generally much easier to speak with a friend at a party, than to approach and start a conversation with a stranger.

5. Restraint Bias

Restraint bias is the tendency of people to overestimate their ability to control their temptations. An inflated self-control belief can lead investors to make impulsive investment decisions rather than ones based on logic and sound analysis. Restraint bias can also lead investors to invest too much capital in what they believe is a sure investment. Given that risk management is critical to good investing, sizing investment positions correctly in our view is just as important as picking the right investments. This means that investors must not overindulge in what they believe to be their best investment ideas.

6. Anchoring Bias

Anchoring bias is the tendency for people to rely too much on pre-existing information when making decisions. Anchoring bias in investing can occur in a number of different ways. For example, an investor that purchases a stock at $10 and watches the stock increase to $12 may be reluctant to add to his position because he believes the stock is now more expensive. However, if there is new information that shows that the earnings power of the company will grow at a much faster rate than previously known, than the stock may actually be a much better investment at $12 than it was at $10. An investor not wanting to add to his position at $12 because it has already risen from his initial purchase price, will be anchoring to pre existing information rather than focusing on the new information which clearly shows that the stock is now a great investment.’

7. Information Bias

Information bias is the tendency to evaluate information which is useless or irrelevant to solving a problem. In today’s world investors are constantly pounded with new information from the media which in many cases is not useful to making logical investment decisions. In order to make informed investment decisions investors must know what information to focus on and what information they should discard.

8. Bandwagon Bias

Bandwagon bias also known as heard mentality is the tendency of individuals to intrinsically want to conform, be part of a crowd, or do things because others are doing them or believe them. Investors tend to feel reassured if they know they are making the same investment decisions as other investors. As a result, many investors will tend to invest in hot stocks simply because they are popular. This leads investors to invest in stocks irrespective of the company fundamentals. In our view in order to be a successful investor one must think independently. This does not mean you should be a contrarian just for the sake of it, but it does mean that you should make investment decisions based on your own analysis not merely because others are investing.

Conclusion

As can be seen from the list above there are many psychological biases that we are all prone to that can lead us to make investment mistakes. The solution to this problem is to employ a disciplined investment process that includes conditions which must be met before we make an investment in order to avoid our psychological biases.