Investment Biases: Why Common Sense Is NOT Common
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We all heard of the common saying like buy low sell high or don’t try to time the market but while these concepts are easily understood, it is extremely difficult to put them into practice.
As investors, we often fall victim to common biases that cause us to behave like wall street bets degenerates while thinking that we are investing like warren buffett.
In this video, I will share with you three common investing biases and how each of these biases impedes us from doing what is necessary to carry out a successful investment operation.
Loss aversion and Recency Bias
Why we can’t buy low & sell high
The first and biggest problem that all investors have deals with the concept of loss aversion and recency bias.
This is the key reason why we kept on buying high and selling low despite knowing that the key to investment success is to buy low sell high.
Loss aversion is the tendency for people to strongly prefer avoiding losses than obtaining gains while recency bias is the tendency to place too much emphasis on experiences that are freshest in your memory—even if they are not the most relevant or reliable
Thanks to our monkey brain, we tend to only process and overweigh the most recent information without considering the cause behind the performance and whether it is justified and sustainable in the long run.
If an investment had experienced a loss over the last 12 months, our monkey brain automatically tells us to stay away from it as we are primed to avoid losses.
This is further exacerbated by the recency bias as it will lead investors to think that the downturn will extend into the future even though the investment may be undervalued.
If an investment had experienced a profit over the last 12 months, our monkey brain would automatically tell us that this investment is good simply because it is not making a loss.
This is further exacerbated by the recency bias as it will lead investors to think that the rally will continue even though the investment may be overvalued.
While our monkey brain understands the math behind buying low and selling high, our animal instinct is the one that prevents us from doing what is right.
While we know that we should be buying low and selling high, we often end up buying high and selling low because it feels good to buy something that had previously done well and it feels like shit to buy something that had previously done poorly.
When presented with a set of information, we place too much emphasis on what has happened in the last twelve months, and we end up favouring things that had performed well and avoiding things that had not even though we were told countless times that past performance does not signify future performances.
That is why buy low sell high is easily understood but rarely practised. Moving on.
why we can’t stop ourselves from timing the market
The second problem that all investors have revolves around the concept of prospect theory.
This is the key reason why we are unable to stick to the simplest, time tested strategy of dollar-cost averaging and we often find ourselves trying to time the market – be it knowingly or unknowingly – despite the fact that we know to time the market is a fool’s errand.
The prospect theory says that investors value gains and losses differently more specifically it states that individuals would rather avoid losses than similar gains – because losses create a stronger emotional effect than gains.
Simply put, we feel more pain for a dollar of loss as compared to the pleasure from a dollar of gain. As a result, we tend to have a strong tendency to prioritize locking in our gains in fear of suffering a potential loss down the road.
Because of that, when prices are increasing, we will start to question ourselves as to whether or not we should continue dollar-cost averaging when the prices are increasing or whether or not we should just sell off, take profit and buy back in again when the dip or correction happens.
On the other hand, when the market is dipping, we find ourselves questioning whether or not it makes sense to buy more as the market price is dropping and if we should sell off our investments now and buy back in again after the dip or correction had finished avoiding further losses.
It just goes to show that no matter how smart or how rational we think we are.
At the end of the day, we are still susceptible to emotionally driven decisions that make us feel better about ourselves in the short run but sabotage our investment performances in the long run.
As evolved monkeys, we understand the effectiveness of market timing and constantly preach against trying to time the market. But when it comes to practising what we preach, most of us fall victim to our irrational emotions and end up trying to time the market in one form or another regardless of whether you do it consciously or unconsciously.
That is why it is very difficult for us to have the discipline to pull off a straightforward investment strategy like dollar-cost averaging. We can’t help but to second guess ourselves each time the price moves – be it up or down.
Why do we always think that we are right
The third problem that all investors have deals with is the concept of confirmation bias.
This is the key reason why investors often realize their mistakes too late resulting in large losses in their investments when they could have been easily avoided.
Confirmation bias is the tendency for us to seek out information that supports our beliefs and ignore information that contradicts them. As a result, we often turn a blind eye to valuable information that could have helped us spot and avoid potentially costly mistakes.
Despite knowing fully that we should process all relevant information accordingly instead of selectively, we can’t help ourselves but to search, interpret and recall information that confirms our beliefs.
The reason why we do this is that it helps increase our self-esteem and alleviates the stress of having to deal with information that contradicts our beliefs.
We do it because it is easy and it feels good despite knowing fully that it leads to poor investment decisions that are usually one-sided and self-reinforcing.
Confirmation bias is also the reason why investors tend to become overconfident and may fall victimized by financial bubbles.
This is extremely prevalent especially in a digital age where it is very easy for like-minded individuals to come together and form an online community.
Basically, with the abundance of social media platforms, it is easy for individual apes to come together and behave like sheep.
As what all wallstreetbets degenerate would say, apes together strong.
Once again, while we all understand the dangers of group thinking and herd mentality, our ape-like instincts can't help but herd together and act like sheep.
What can you do to become a better investor?
Now that you have a general understanding of the common human tendencies and biases that affects the quality of our decision and sabotage our investment performances, what can we do about it?
The first thing we can do is to recognize that all of us humans are at the end of the day, irrational monkeys. It doesn’t matter how smart or how rational we think we are, as humans, it is inevitable that we are susceptible to the emotional and irrational modes of thinking from time to time.
By recognizing that we are not perfect, it allows us to catch ourselves when we are behaving irrationally instead of going along with our emotional impulses. Acknowledge that we are flawed and make an effort to ownself check ownself.
The second thing we can do is to set boundaries for our investment operations and have very clear standard operating procedures when it comes to our analysis and decision-making process.
By establishing very clear rules and procedures behind how you make decisions, it allows you to be laser-focused with regards to your investment methodology and it results in a high degree of consistency behind your every action.
Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides:
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This article is meant to be the opinion of the author
This article is for information purposes only
This article should not be seen as financial advice
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