Recognising and Avoiding Common Behavioural Biases to Improve Investment Decisions

When investing in the stock market, most investors tend to overly focus on the scientific aspect. This leads them to leave the emotional side of investing completely unaddressed. As humans, we are inherently emotional by nature, and disregarding that aspect of ours can never lead to optimal outcomes, especially when investing. Instead, we must recognise behavioural biases and consciously try to avoid them.

In this article, we are going to explore some of the common behavioural biases you are likely to encounter when investing and practical solutions for effectively avoiding them.

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• Behavioural biases are inherent psychological tendencies that can negatively impact investment decisions.
• Recognising and addressing the various behavioural biases is crucial for optimal investment outcomes.
• The key to overcoming these biases lies in self-awareness, discipline, and a commitment to developing an objective and structured investment approach.

Behavioural biases are inherent psychological tendencies that can either subtly or overtly influence our judgment and decision-making processes. Usually, these biases influence us in ways that we are not consciously aware of, leading us to make decisions that may not align with our best interests or long-term financial goals.

Now that you are aware of what behavioural biases are, let us closely examine five of the most common biases you are likely to encounter when investing and how you can avoid them in the future.

1. Confirmation bias

Confirmation bias refers to the tendency of investors to actively look for data that agrees with their beliefs while not paying attention to contradictory evidence. This particular bias can be dangerous when investing since it can lead to an echo chamber effect, where investors only pay attention to news and analysis that supports their current investment strategy or logic.

How to avoid

To avoid confirmation bias, investors must make conscious efforts to seek out diverse opinions and information that contradicts their beliefs. By considering both for and against arguments for their investment strategy, investors can mitigate confirmation bias to a large extent.

2. Loss aversion bias

Loss aversion bias, also known as holding-on bias, refers to the tendency to strongly hold on to a losing position believing that it would somehow make a dramatic turnaround and generate profits. This behavioural bias stems from the psychological tendency of people to feel more strongly about losses than gains. If not addressed properly, this bias can push investors to hold onto losing positions for too long or avoid taking necessary risks.

How to avoid

Fortunately, loss aversion bias can be addressed by setting clear, rule-based criteria for buying and selling investments. Investors may also consider setting stop-losses for their investments, which can not only protect them from falling for this bias but also ensure that their capital does not erode due to adverse market movements. Stop-loss orders automatically exit a position when a particular price is reached, eliminating the need for manual intervention.

3. Overconfidence bias

One of the most common behavioural biases that investors are prone to is the overconfidence bias. It is the tendency to overestimate abilities, from the quality of judgment to the accuracy of forecasts. Being overconfident when investing could potentially lead to excessive trading, under-diversification, or taking on too much risk. When left unchecked, it could have a significant negative impact on investment outcomes.

How to avoid

The best solution to avoid overconfidence bias is to maintain a detailed investment journal recording all of the investment decisions, including the reasoning for the decision, the expectation, and the result. Investors must review this journal regularly to assess the accuracy of predictions. This simple exercise can help them identify whether they have been overconfident when investing or whether their decisions were all made through logic and reasoning.

4. Herd mentality bias

Herd mentality bias, also known as the bandwagon effect, is another very common behavioural bias investors have. It is the tendency to blindly follow the actions of a larger group without thinking of any other alternative or listening to the reasoning.

Herd mentality is one of the primary reasons for the formation of a bubble when investing. As more number of investors continue to invest in a trending stock following the others, the stock price is driven up unnaturally high, leading to a bubble.

When the bubble finally bursts, the investors suffer significant losses. The same bias can be witnessed at times of panic selling during market downturns, where even a minor piece of information can spark a widespread wealth wipeout.

How to avoid

To avoid this behavioural bias, investors must develop and stick to a personal investment strategy based on their goals, risk tolerance, investment horizon, and thorough market research. Also, being overly cautious of rapid price increases without corresponding fundamental improvements is another simple, yet effective way to avoid falling for the herd mentality bias.

5. Anchoring bias

Anchoring bias refers to the tendency to rely heavily on the first piece of information that investors are exposed to when making investment decisions. When investing, this often leads to fixation, where investors use the first piece of information they gathered as a reference point for future decisions regardless of new information.

How to avoid

Regularly reassessing investments based on current data and future prospects is one of the best ways to avoid this behavioural bias. Investors must also ensure they use multiple valuation metrics and compare companies with their peers when making investment decisions. Investors can successfully avoid fixating on a particular piece of data by simply being open to changing their minds as new information becomes available.

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Behavioural biases are an inherent part of human nature. No investor, including professionals, can ever be entirely immune to their influence. However, understanding these biases and taking active steps to counteract them can significantly improve the decision-making process. Also, it is crucial to remember that successful investing is never about being right all the time. In fact, it is about making rational, objective, and well-informed decisions consistently over time