For as long as conflicting opinions have dominated the stock market, behavioural finance and investor psychology have been underlying principles. This involves trying to understand and rationalise the investment decisions we make.
However, cognitive biases can interfere with our investment decisions, ultimately hindering rational decision-making and potentially leading to crucial mistakes. It is one thing to be confident in your thought process, however, taking shortcuts or exhibiting overconfidence can be a significant disadvantage.
Because long-term share investing is as much a test of one’s psychological mettle, it is important that you understand how to manage cognitive biases as an investor. This may help you improve the sustainability of your returns by reducing your risk exposure.
Let’s discuss some of the most common cognitive biases associated with shares.
Have you ever heard of the expression that past financial performance is no guarantee of future performance? This relates to anchoring bias, which is the tendency to ‘anchor’ your expectations to historical reference points when making an investment decision.
An example of this would be where you invest in a stock because it is well below a historical trading range or the price at which you previously bought shares. You might be using the company’s historical share price to guide your expectations as to its future price. Many traders rely on technical analysis to guide price expectations, however, this differs because it is based on evolving trends that revise expectations.
On the other hand, if you are a long-term investor, it is dangerous to assume a stock may return to a historical price just because it once traded at that price. Instead, you should take into consideration the broader context behind the deviation in the share price to understand what has changed. There may be fundamental reasons that make historical trading prices ‘redundant’. Alternatively, you may even choose to ignore historical prices and focus on intrinsic stock valuation.
Confirmation bias is where we seek out information that supports or confirms our existing views on a stock and disregards contrarian views. Without realising, you might be collecting data that reinforces your investment thesis but does not include all the information that is publicly available. In fact, this may tie-in with another bias, groupthink, which could lead to a false sense of confidence, a lack of independent analysis and poor judgement.
While no one likes to be told that they are wrong, it pays to consider every share investment with an open mind rather than being emotionally attached. To overcome confirmation bias you should actively and regularly seek out contrary information that challenges your investment thesis and offers a complete picture, thus increasing the likelihood you make an appropriate investment decision.
Shareholders often have a hard time parting ways with a stock that is currently trading at a ‘paper loss’. Many hope to claw back their capital. Loss aversion explains this tendency, suggesting that we sometimes prefer to avoid losses than realise gains. A similar bias called the endowment effect involves holding onto a stock due to increasing bullishness as the price rises. You can mitigate this if you stick to the objectives of your trading plan.
Behaviour associated with loss aversion goes against the fundamental principle of opportunity cost, which is the ‘lost’ gain when you invest in one opportunity instead of another. While you might be inclined to hold onto shares that are currently trading below your purchase price, you should ask yourself whether your capital is best allocated to those stocks. Could you achieve higher returns if you invested in other shares?
Continually assess your trading account to gauge whether alternative shares represent better value. Losses often magnify. Try place yourself in the shoes of someone else to frame your judgement as to which shares will maximise your portfolio. Furthermore, view your past decisions as a sunk cost that has no bearing on the current decision in front of you.
Have you ever found yourself in the middle of a good streak where you thought that you were on a roll? We often tend to convince ourselves that this success is likely to continue even though each successive event is mutually exclusive.
In the stock market, traders regularly exhibit this tendency, otherwise known as hot-hand fallacy. It may be because you are overconfident in your strategy, however, it can often lead investors to start taking shortcuts and relying on instinct. This is why it is important that you do your research on every opportunity before you decide to invest.
Sometimes this fallacy extends to ‘hot’ trends in the stock market, where investors assume they will continue. Momentum investing can work, but nothing is a given, especially when the trend reverses. Just ask shareholders of cannabis stocks how this strategy has fared for them over the last 18 months.
Why managing bias is important
Over the long haul, the stock market can be a true test of attrition. To position yourself to achieve sustainable returns it is beneficial to understand your behavioural mindset when investing in shares.
It is only normal that we exhibit cognitive biases in our investment decisions, however, overcoming these biases is a key differentiator that can help you make rational judgments and avoid costly mistakes. For the sake of improving your long-term investment success, you may just appreciate what another perspective can help you achieve.
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