5 Common Behavioral Biases That Every Investor Should Know.
Ever heard of Tech gender problem? It is a situation where the employer favors male candidate over female thinking women are no good at tech because they are women.
Even one of the biggest companies in the world, Amazon, faced this bias. (Read more here: Amazon’s machine-learning specialists uncovered a big problem: their new recruiting engine did not like women — The Guardian.)
Anyways, gender bias is nothing new. Throughout history, when jobs are seen as more important or are better paid, women are squeezed out. And similar to this one, there are multiple common biases that we can notice in our day to day life.
But, what actually is a bias?
According to Wikipedia– “Bias is disproportionate weight in favor of or against one thing, person, or group compared with another, usually in a way considered to be unfair.”
In other words, it is an inclination or preference that influences judgment from being balanced. Biases lead to a tendency to lean in a certain direction, often to the detriment of an open mind.
Behavioral Biases in Investing:
Investors are also ordinary people and hence they are subjected to many biases which influence their investment decisions. Although it takes time to control the behavioral biases, however, knowing what are these biases and how they work — can help individuals to make rational decisions when they are susceptible to these situations.
In this post, we are going to discuss five common investing biases that every investor should know.
When a human mind is determined towards one particular behavior, it subconsciously rejects the pieces of evidence against it while confirming the ones that go in its favor. This is known as confirmation bias.
Psychologically speaking, an investor would be more inclined towards his pre-occupied information and knowledge about certain kinds of investing. While considering the pros and cons of a certain kind of investment, the buyer would most likely go with what he used to believe until now.
For example: Making an investment in Bitcoin is dangerous and pointless. If this is an investor’s pre-occupied notion then he would most likely not invest in bitcoins in future.
Gambler’s Fallacy is one such proof which states that a human mind often interprets the outcomes of a future event judging by its corresponding past events even if the two are completely independent of each other. It is inspired by the “failures of gamblers” due to their probabilistic illusions to make decisions in casino games.
Gambler’s Fallacy can be very well explained with the help of a basic example involving a coin. For future reference, let’s suppose that the coin is fair with both sides (heads & tails) having an equal probability of landing on top.
Suppose a coin is flipped 10 times and the result of each event was “Heads”. What would you bet for the next coin flip?
Now, if a human bet on the outcome of the 11th flip of the coin to be “Head” seeing the past events, then it can be considered a bias.
The above context does only imply a simple rule: The occurrence of an independent event is not dependent on past events. In this example, the 11th flip of a coin would result in both heads and tails with a 50% chance of being associated with each one of them.
The regret after purchasing a product is called a buyer’s remorse. Here, the buyers may regret that either they overpaid for the product or they didn’t actually need that product.
Nevertheless, purchasing commodities are not the only thing where people feel “buyer’s remorse”. Stock investors are also like ordinary people, and they too feel this remorse after purchasing equities.
“Was buying this stock a mistake?”
“Was my timing right?”
“Did I just buy a lemon of a stock?”
“Is the market going to collapse?”
“What if I lose money?”
In general, investors feel remorse when they make investment decisions that do not immediately produce results.
An investor’s natural instinct goes with the ones of masses, which means that he/she doesn’t seem to have a rational view on a certain investment but is more likely to deviate where the majority mass is moving — this little phenomenon is known as the “Herd Mentality”.
The term has been derived from the natural instinct of a number of sheep walking together in a herd so as to avoid falling into the pitfalls of danger.
Interestingly, you can also find a large population of investing community following herd mentality psychology in making various financial decisions like buying new property or investing in the stock market. Seeing others getting profited with an investment, our brain tells us to go for it without a second thought.
A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.
As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”. But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.
Such scenarios are quite noticeable everywhere, including investing.
In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is most of the time disadvantageous for the investors. Another example of winner’s curse is bidding in expensive IPOs.
Most biases are pre-programmed in the human nature and hence it might be a little difficult to notice them by the individuals. These biases can adversely affect your investment decisions and your ability to make profitable choices.
Anyways, knowing these biases can help you to avoid them causing any serious damage. Moreover, a good thing regarding these biases is that — like any habit, you can change or get over them by practice and efforts.
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting