MENU

3 Cognitive Biases That Can Affect Your Investing Decisions

Psychologists have long studied the human brain to see how our surroundings affect the way we think and act. Through their research, they have identified a list of cognitive biases that can lead to irrational decision making.

Some of these cognitive biases can sometimes affect our investment decisions. Therefore, it may be important to identify what these are and how we can prevent them from causing us to make judgment errors. Here are three bias tendencies that investors should be aware of.

Anchoring or Focalism

This is a tendency to focus on a single piece of information when making decisions. Anchoring can be particularly dangerous when it comes to picking a stock.

The future performance of a company is a complex interrelation between many factors. This includes the strength of the management, the growth of the industry as a whole, the competitive advantage the company may possess, the potential risks involved with the business, etc. If we make a decision solely based on one single factor, we may end up missing vital information.

Disposition Effect

Disposition effect is a tendency for us to sell an asset or investment that has gone up in value rather than an asset that has declined in value. When deciding on which stock we wish to liquidate, instead of looking at the returns on our investment for each stock, we should be re-looking at the fundamentals of the company and relate back to the price of the company.

Sometimes it may be difficult to admit but the stock that we had picked earlier may just not be living up to expectations due to a change in the company’s fundamentals and we may need to sell it at a loss. Good investment strategies are not only based on what you buy but also managing your portfolio wisely and being true to yourself if you have made a mistake.

Confirmation Bias

Confirmation bias is the tendency for us to focus or remember information that confirms our assumptions. For example, we may have been recommended a stock by our friend and decide to go back home and do some research on that particular stock ourselves.

However, as we have already been given a preconception that the stock has solid fundamentals, we may only focus on bits of information that reaffirms this belief. We will tend to ignore or down play other information that points to a different direction. This can be dangerous when we choose stocks as confirmation bias may reduce our capability to make informed investment decisions.

The Foolish Bottom Line

Cognitive biases play a part in our daily lives and sometimes lead to irrational decisions. Investors should be aware of these tendencies and ensure that they do not negatively affect our investment decisions.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

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