Recognizing the five cognitive biases of self-directed investing
June 24, 2021
It is important to recognize the five cognitive biases of investing. Money is a powerful tool in our day-to-day lives. There are various emotional connections and cognitive biases that impact how we spend, save and invest our money. When it comes to investing, you perform the best when making informed decisions and approaching the market methodically and rationally.
Investing behaviour is defined not just by the act of buying and selling investments, but also by the psychological traps and misconceptions we have to recognize in ourselves. Below, learn more about how you can recognize these biases and take a more calculated and successful approach with your investing. Educating yourself on the possible pitfalls of self-directed investing is an important way to reach your investment goals.
- Overconfidence Effect: this is a well-established bias in which your confidence in your judgment does not align with your actual accuracy and results. In investing, this can lead you to overestimate your understanding of the stock markets, ignore or disregard information and expert advice, take greater risks that may not be suitable for you, and ignore red flags of poor investments and fraud.
- Herding Behaviour (aka. FOMO Effect): is often linked to wild and irrational stock market bubbles, herding is the tendency for us to want to follow the crowd. The fear of missing out on the next big investment can influence you to make investment decisions in line with what you see and hear from others and less so on the fundamentals of the company you are considering. Fundamentals include profitability, revenue, assets, liabilities, and growth potential
- Confirmation Bias: is when you have preconceived notions about a company or investment and seek out information that supports your beliefs rather than building a comprehensive understanding through objective research and data. This bias can convince you to invest in companies with a skewed sense of its business potential.
- Loss Aversion: is the tendency for you to place more importance on losses rather than gains. This can lead you to hold on to a stock that continues to drop in value while all current rational analysis tells you to sell it. Inversely, this could also have you selling a stock that went up in value slightly to realize a gain, while ignoring analysis telling you that it should be held longer for a much greater profit.
- Anchoring: is when you anchor your opinion and value of an investment to one piece of information or price and ignore the company's fundamentals. Worse yet, anchoring can quickly lead to confirmation bias, having you look for additional information that aligns with your anchored belief in the stock.
Investing in the stock market on your own can quickly bring out these biases, impacting your investment portfolio. By recognizing when you are being influenced, you can better address the bias and ensure that your investment decisions are based on rational analysis. If investing on your own may sound too challenging, financial advisors and robo-advisers can lay out an investment strategy that will help you invest for the future and avoid these common psychological traps. For more information on investment tips, advice, and how to avoid fraud go to Alberta Securities Commission at www.albertasecurities.com.
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