According to Benjamin Graham: “The investor’s chief problem—and even his worst enemy—is likely to be himself.”
The underlying reason is that the vast majority of investors are irrational. We all have biases that can lead us to take the wrong decision. There is not much we can do about it because we are not machines but… acknowledging that there biases and understanding them, next time we face one, we might be able to spot it, do something about it and probably take a better decision.
In the investment process, investors often experience the “roller coaster of emotions”. Does this look or feel familiar?
If so, you’re not alone. After all, the cyclical investment process is full of psychological pitfalls. However, only by becoming aware of and actively avoiding behavioral biases can lead investors to take better and hopefully impartial decisions.
Bias does not always have a negative connotation. They can help us in our day to day lives but when it comes to investing, they might have the opposite effect. There are two categories of bias: cognitive and emotional. In the first case we might misinterpret information and data and/or wrong memories. In the second case, people act based on feeling and emotions instead of facts.
When it comes to investor’s biases, we can identify four of them.
Investor overconfidence can lead to excessive or active trading, which can cause underperformance. In a 1999 study, the least active traders had annual portfolio return of 18.5%, versus the 11.4% return that the most active traders experienced.
Fear of loss. When asked to choose between receiving $900 or taking a 90% chance of winning $1000, most people avoid the risk and take the $900. This is despite the fact that the expected outcome is the same in both cases. However, if choosing between losing $900 and take a 90% chance of losing $1000, most people would prefer the second option (with the 90% chance of losing $1000).
The "disposition effect" is the tendency of investors to sell winning positions and hold onto losing positions. This effect directly contradicts the famous investing rule, “Cut your losses short and let your winners run.”
Portfolio Construction and Diversification
Familiarity Bias. Investors prefer to invest in "familiar" investments of their own country, region, state, or company.
Misuse of Information
Gambler’s Fallacy. When asked to choose which is more likely to occur when a coin is tossed—HHHTTT or HTHTTH—most people erroneously believe that the second sequence is more likely. The human mind seeks patterns and is quick to perceive causality in events.
Attention Bias. A 2006 study posits that individual investors are more likely to buy rather than sell those stocks that catch their attention. For example, when Maria Bartiromo mentions a stock during the Midday Call on CNBC, volume in the stock increases nearly fivefold minutes after the mention.
Investing money is a strategic process. Learn your blind spots, develop a systematic strategy and be part of that 20-30% that can make money in the financial market.
Source: this article was a re-edit of Why Investors Are Irrational, According to Behavioral Finance from Melissa Lin
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