Learn about the psychological biases that can influence investment decisions. Understand the implications of them and how you can avoid them.
What is a Psychological Bias
Psychological biases are inherent tendencies or prejudices that affect the way individuals make decisions and judgments. These biases can have a significant impact on various aspects of life, including investing. In the context of investing, psychological biases can lead to irrational behavior, distorted thinking, and poor investment choices.
An investor’s perception of the current market situation and events serves as the primary driver behind every significant investment decision. Consequently, investors must develop a comprehensive understanding of the various psychological biases that can influence their judgment and the potential implications these biases may have on their investment performance.
Types of Psychological Biases of Investors
Overconfidence Bias
Overconfidence bias is a psychological tendency where the investor thinks that he has a higher level of knowledge or skill than he actually possesses. This bias invites an investor to assume too much risk or predict that future performance will be too strong. An investor rose to risk because of overconfidence and unrealistic optimism.
The overconfident bias could get relatively dangerous if the overconfidence causes that overconfident investor to, in some way, neglect the message that one needs diversification and risk management. It may result in over-trading and under-diversification by investors, and, of course, the neglect of information or evidence that would have worked against the original decision.
Bandwagon Bias
Bandwagon bias, also known as herd mentality or groupthink, refers to the tendency of investors to follow the crowd and make investment decisions based on the actions of others. This bias can lead to market bubbles and irrational exuberance, as well as herd selling during periods of market panic. Investors influenced by bandwagon bias often fail to conduct independent research and analysis, instead relying on the opinions and actions of others.
Availability Bias (Trend Chasing)
Availability bias, also known as trend-chasing, occurs when investors place undue importance on recent information or trends when making investment decisions. This bias can lead to a myopic focus on short-term market movements, causing investors to buy high and sell low. Availability bias is often fueled by media coverage and the constant flow of information.
Loss Aversion Bias
Loss aversion bias is a tendency for investors to feel the pain of losses more strongly than the pleasure of gains. This bias can lead to irrational decision-making, as investors may hold onto losing investments for longer periods in the hope of recovering their losses. This can result in missed opportunities and reduced portfolio performance.
Confirmation Bias
Confirmation bias occurs when investors seek out information that confirms their preexisting beliefs and ignore information that contradicts them. This bias can lead to a distorted view of reality and hinder the ability to make objective investment decisions. Investors who are affected by confirmation bias may become overly confident in their investment choices and fail to consider alternative viewpoints.
Regret Aversion Bias
The third bias that investors can be prone to is regret aversion bias. This is the fear of making an incorrect investment decision that is later regretted. There is an eventual result of missed investment opportunities since this tendency eventually causes the investor to be risk-averse. Some investors would rather settle for possibly lesser returns from safer investments as compared to taking calculated risks when they are victims of regret aversion bias.
FOMO (Fear of Missing Out)
FOMO, or the fear of missing out, is a psychological bias that drives investors to make impulsive investment decisions based on the fear of missing out on potential gains. This bias can lead to irrational behavior, such as chasing hot investment trends or buying into speculative assets without proper due diligence.
How to Avoid Overconfidence as an Investor
Overconfidence is a psychological bias that can hurt investors, especially if they are too overconfident. Overconfident investors either take unnecessary risks or do not diversify enough, which results in huge losses at the end of the day.
An investor can, therefore, do an appraisal continuously and always challenge his assumptions and personal beliefs. Objectively, an investor must know and understand the risks that his investments could involve and the probable outcomes of several instances, including the pursuit of divergent opinions through scenario analysis, and consideration of alternative views. Furthermore, an investor must maintain a sense of skepticism and should always question one’s analysis.
Another approach to counter the brunt of overconfidence can be to channel the resourceful attribute to develop a systematized and disciplined manner of investment strategy. A very strict and predefined set of rules or guidelines. This can keep an investor away from any form of emotional attachment and prevent him from introducing personal biases into a decision.
How to Avoid Regret Aversion as an Investor
Regret aversion is the psychological bias in which people shun their actions in which their potential consequences bring them a feeling of regret, though holding rationality or necessity for long-run success. If an investor is regret-averse, he will hesitate to sell the losing investment since the market may turn in his favor, which will make him avoid feeling regretful at taking a loss.
It is this pressure, at some point, that regret aversion refers to in the sense that thought must finally be given to the actual underlying fundamentals and prospects of their investments, as opposed to short-term price movements. This way, deep research and analysis can be put into the risk and potential reward of one investment over another, without making decisions that would result in regret. It might be of help in building up confidence in a decision-making process.
What Can Investors Do to Avoid FOMO
Fear of missing out (FOMO) is a psychological bias that can have a significant impact on investment decisions. It refers to the anxiety or apprehension individuals feel when they believe others are experiencing opportunities or successes that they are not. Investors affected by FOMO may be tempted to chase after the latest investment trend or follow the crowd, often disregarding their own investment strategy or risk tolerance.
To avoid succumbing to FOMO, investors should establish a well-defined investment strategy and stick to it. This strategy should be based on individual financial goals, risk tolerance, and investment timeframe. By having a clear plan in place, investors can resist the temptation to make impulsive decisions driven by FOMO and instead focus on their own long-term objectives.
Another strategy to counter FOMO is to conduct thorough research and due diligence before making any investment decisions. By carefully analyzing the fundamentals and prospects of an investment, investors can make informed choices based on their own assessment rather than relying on external influences. This can help mitigate the fear of missing out and provide a more rational and disciplined approach to investing.
Furthermore, investors can benefit from surrounding themselves with a supportive network of like-minded individuals. By engaging in discussions and sharing insights with other investors who follow a similar investment philosophy, investors can gain a sense of perspective and reassurance. This can help alleviate the fear of missing out on opportunities and provide a more balanced and objective approach to investing.
