Three Mental Biases in Investing and How To Avoid Them

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Even if we hate to admit it, there will be times when we’ll make investment errors due to our emotions and behavioural biases. Let’s look at some of the common biases we have and how you can avoid them.

Overconfidence Bias

If you’ve ever polled your friends, asking if they are a “better than average” driver, you will likely realize that most of them will say they are.

In fact, if you’ve polled random groups of people, the same result should surface too. But, by definition alone, it is simply not possible for more than 50% of the people to be “above average” drivers. In this case, what those who have been polled are displaying is a classic case of an overconfidence bias.

Similarly, in the investment world, many will feel that they have an edge over others. They might also think that they have better insight or better intelligence over the average investor.

Thing is though, it will be wise for us to constantly fight against this bias and remain humble in the market place as the market has a penchant of making a fool out of us more often than not.

Confirmation Bias

If you have invested in any of the 30 companies that make up the Straits Times Index (SGX: ^STI) – some of the largest publicly-listed companies in Singapore – there should be numerous research reports on them by the brokerage houses.

Now, have you ever realised that you might tend to put more weight on reports that agree with your views and brush off reports that are not? This is an example of a confirmation bias, where we tend to seek out information that agrees with our preconceived notions of how things should be.

A good way to fight this bias is to really understand the risks behind each of your investment.

Loss Aversion

Quick question: Do you know someone who has bought a stock that has gone down so much in value that he or she just does not want to sell it for fear of realising those losses?

If you do, please talk him around for the simple reason that funds that are channeled out from the hopeless stock into ones with better potential would be way more beneficial.

This irrational fear of selling losing our investments, termed loss aversion, is one of the most common biases that we display.. In investing, it is impossible for us to be right all the time. So,we have to learn to take our losses and reinvest them in better opportunities.

Foolish Bottom Line

You can only change if you know. Recognizing the problem is the first step in finding a solution. Don’t be embarrassed to admit if you have these biases  – they happen even to the best of us.

One good way to prevent us from falling prey to our biases is to keep a log book on all our investments. In it, we would write down our reasons for investing in a stock at that point in time. In this manner, we can periodically check up on our investments to see if they are panning out in the way we had assumed and not succumb to rash, emotional decision making.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.