Humans are never perfect. We as a being are far from perfection and thus seek to improve ourselves every day. Investing in the stock market is no different. Every stock investor possess one or more of the behavioral biases that I will talk about in this article and should seek to make a conscious effort not to allow these innate characteristics to sway your investment decision making which might cause you to earn less money in the stock market. Below of some examples of behavioral biasness; the characteristics associated with them as well as some methods to counter them.
REPRESENTATIVENESS : LOOKING AT THE PAST BUT NOT THE PRESENT
Representativeness is a bias based on an investor using past experiences to make current decisions. For example, most investors use past year performances of the company to make investment decisions. If the company has been doing well for the past 5 years and revenue has been growing, they automatically assume that the company is a successful one without taking into account current market conditions and competitive landscape which might adversely affect the company. An investor who wants to counter biasness from representativeness should not only take information from the past but from the present as well to make an informed investment decision.
OVERCONFIDENCE : TOO MUCH FAITH IN ONESELF
An investor exhibiting overconfidence tends to place too much confidence on one self, which can lead to surprises. He or she will tend to trade more frequently than justified. Overconfidence is also associated with optimism: they feel that the odds of bad things occurring are very low. The primary factor that leads to overconfidence is knowledge, education and experience. Investors feel that they have superior skills compared to others and therefore make forecasts based upon the illusion of their skill and experiences alone, not in disciplined fundamental research. An investor who wants to counter biasness from overconfidence should always be humble and acknowledge that the pursuit of knowledge is endless and should always ensure that every investment decision made is done through a thorough due diligence process and not just merely on his or her past experiences or skills. He or she should also correctly weigh the odds of good and bad outcomes and not to be overly optimistic about favorable events happening.
ANCHORING AND ADJUSTMENT : INABILITY TO FULLY ADJUST THE IMPACT OF NEW INFORMATION
Sometimes investors tend to underweight new information that is presented to them. That is, they fail to adjust their investments and as a result project their estimates incorrectly. Most of the time, they tend to be too conservative on good news and too defensive on bad news. There is no easy way to counter this since it is an innate personality but investors should be aware of this fact and be conscious of it when making any adjustments to their projections based on new information so that they can attempt to make more sound investment decisions.
AVERSION TO AMBIGUITY : FEAR OF THE UNKNOWN
An investor who has an aversion to ambiguity is afraid to trade stocks out of his or her comfort zone. For example, they trade only on stocks or companies that they are familiar with and ignore the rest, resulting in a portfolio that is undiversified with a lot of risk. Like with anything in life, the only way to learn is to get out of your comfort zone and experiment with new portfolio management methods and new stocks to invest in. You can use a small percentage of your portfolio to try out new stocks or instruments that you have not used before. As you get comfortable and familiar with them, you can invest more of your capital into it. The goal would be to achieve a diversified portfolio and attaining better knowledge about the stock market. Of course, fundamental analysis is still key to stock investing success and no investor should replace hard work with impulsive decisions.
LOSS AVERSION : RELUCTANCE TO ACCEPT A LOSS
Loss aversion is a mindset where investors hold on to losers for hope that they will eventually go back up. They are also hesitant to enter the market when it is falling because they believe that it might fall even further. This is one of the most common biasness in the market. By holding on to losers which have bad fundamentals, it will result in the price of their stocks going down even further in the long run. Investors who possess stocks with bad or deteriorating fundamentals should sell their stocks as soon as they realize it. Because the stock is definitely not going to improve until the fundamentals improve. Also, when the market is down, it is actually one of the best times to enter the stock market because it will be filled with undervalued stocks with good fundamentals. Investors should take this opportunity to search out the gems from the rocks and buy in when valuations are cheap. There might be volatility in the short run resulting in a paper loss, but good fundamentals always rebound the fastest in a recovery.
HERD BEHAVIOR : INCLINATION TO FOLLOW THE GROUP
The last biasness that I would like to point out is the herd behavior. Most of the time, investors do not feel totally convinced by their own investment decisions as they believe that the professionals have better knowledge and experience. As a result, they will follow the so called “leaders” and their decisions, not relying on their own. This is dangerous because there may be a lot of factors that these so called professionals have when they make these investment decisions and the circumstances might not be the same as you. Also, by only following, you would have no clue what you are doing and the sheer number of different views by professionals in the market will make you very confused and lost in the world of stock investing. Always take expert opinions as a guideline or a second advice. But always rely on your own investment research and decision making when it comes to choosing which stocks to buy. If you have no confidence in that ability, it will be best if you just invest in Exchange Traded Funds at the start or rely on a financial advisor at a higher cost.
BEHAVIORAL BIAS : USE IT TO YOUR ADVANTAGE
All these behavioral bias will lead to the investor not being rational in the market, thus making the stock market inefficient. What I mean by inefficient is that these biasness will lead to stocks not reflecting their true value. Because of this, there are stocks which are over and undervalued in the market, creating opportunities for investors to take advantage on.
The strategy would be to first find out what are your biasness by reflecting on your stock investing decisions in the past. After that, try and minimize your inherent biasness through a disciplined and fundamental investment strategy approach. Do not take any shortcuts when it comes to researching on your stocks. Lastly, seek to take advantage of other people’s inability to make rational decisions and find undervalued stocks in the market.