When people talk about investing, the first thing which usually comes to mind is whether an investor has chosen the right stock to buy. The discussion then usually follows to how much of that stock he has bought, and what he feels is the upside or downside over a certain time horizon.
What is less frequently discussed – but is equally important – are three emotional biases which could negatively impact a carefully constructed portfolio and cause investors to lose money.
The first bias is known as hindsight bias and it is very prevalent – even seasoned investors are afflicted by it. Hindsight bias means that investors who already know how an event turned out are fooled into thinking that they knew the outcome all along. For example, many people claim today that they knew Lehman Brothers would go bankrupt when the Global Financial Crisis unfolded in 2008 and 2009.
But the flaw in this logic is clear – people say this with certainty because they are cognizant of the outcome of the two events, and not because they knew beforehand how events would transpire. The best way to avoid hindsight bias is to pen down all investment decisions as we make them, so that we can check back over time on our thought process and avoid assuming that we knew what was going to happen when we actually did not.
The second bias is confirmation bias, where an investor would actively seek out facts or information which conforms to his beliefs, and ignore or discard information which does not. This bias is dangerous because it blinds us as investors to alternative points of view which may invalidate our original investment thesis. In fact, divergent views may make the key difference between a successful investment versus an unsuccessful one. Therefore, it is very important to seek out contrary-views in order to learn and grow as an investor.
The endowment effect is yet another bias to watch out for. This effect would make us feel that the shares we own are somehow more valuable than shares we do not. The endowment effect tends to make us demand a higher price for shares we own, as we perceive them to be more valuable, even if reality may suggest otherwise.
The three biases I mentioned above are just some of the psychological stumbling blocks we face as an investor. I will be discussing more of such biases in future articles. [Editor’s note: An article covering three more psychological biases has been published. It can be found here.]
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