Some form of bias affects us all and this is something which can be hard for individuals to recognize in themselves. Unfortunately, this is true in many areas of our lives and investors can also be affected by different types of behavioral biases ultimately clouding their judgment when they are making investment decisions. What follows are a few common types of bias that can negatively impact investment decisions.
Confidence is a desired quality in an investor. Over-confidence, however, can be quite detrimental. Over-confidence can occur when an investor experiences a certain amount of success. While he or she certainly put the time and effort into choosing the investments, good fortune may very well have played a part in it, too. We call this luck.
When the investor starts to ascribe this success, purely, to his/her market savvy, then this can develop into over-confidence in their abilities. This is referred to as “optimism bias”. The investor feels he/she is smarter than others and, therefore, has an edge in picking the right investments, regardless of what actual past results would indicate. Confidence needs to be tempered with common sense.
Another behavioral bias which can cloud investors’ judgment is an “aversion to loss”. Lost money feels bad. Losing anything feels bad. It causes us pain. As a result, this bias gets into our heads and makes us a little too cautious sometimes. It is OK to be a cautious investor; it is just smart. However, being overly risk averse or being too timid can make investors afraid to act – even if it is in their own best interests.
Another bias many investors have, which most people recognize but cannot shed so easily, is our “past experiences.” Our successes and/or failures with a particular stock or market color our judgment. It makes it extremely difficult for investors to change strategy as the market changes. It can be too easy to fixate on a certain aspect of an investment and expect the market to act as it has in the past when these things may be entirely unpredictable. In real life, getting burned by a hot stove teaches us not to touch it again, but in investing, this is not always the best advice.
There are more and more choices for products and services today than ever before. Walk down the bread aisle of any grocery store and you will find a large variety of bread. While you may not be intimidated by a large choice of bread, a large choice of investment products can lead to paralysis – so much information to consider. Too much information can almost force an investor into choosing, without fully investigating, or not choosing at all.
Behavioral biases are easy to spot in other people, but we tend to ignore our own. A good, smart investor needs to be a bit introspective and discover a few things about his/her patterns and behavior if he/she wants to make smart and sound investment decisions. These biases are all the more reason to consult a financial advisor or registered investment advisor.
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