Mistakes Investors Make: Biases and heuristics (part 2)
With several different types of biases, the second part of the biases and heuristics series continues on the top 5 biases shared by investors. Understanding biases and heuristics can help investors avoid common pitfalls investors make.
Some of the most common mistakes (or biases) investors make include:
1. Recency effect bias
Recent events take a prominent position in an investor’s ability to remember the past. For example, an investor may feel if the market underperforms in the recent past, it will continue to underperform, and if it outperforms, it will continue to outperform. In other words, investors tend to focus more on short-term performance closer to the event versus long-term performance further away from the event.
2. Confirmation bias
Confirmation is a bias used by investors to use information that agrees with their point of view on an investment. An investor may actively seek out news or analysis that supports an investor’s existing view. An investor with confirmation bias will continue to support flawed investments and reject any new information that doesn’t fit the investor’s narrative.
3. Bandwagon effect bias
The tendency for investors to follow each other or literally jump on the bandwagon cause the market to rise or fall excessively. For example, when the market is going up, speculation continues to push higher prices even higher. Alternatively, when the market is going down, excessive selling and lower buying causes the prices of shares to crash. Sometimes, it pays to not follow the bandwagon. One case that’s not related to investing includes Hugh Thomspon Junior, an American soldier that placed his helicopter and life between his own troops advancing towards unarmed women and children during the massacre in the Vietnam war. Thompson saw a high number of unarmed civilian casualties and deaths, which resulted in him telling his own troops that if they opened fire on the Vietnamese civilians his squad would open fire on the US army.
4. Information bias
The tendency for investors to use information that is biased, or is not relevant in making investing decisions. Investors have access to ample data, studies, analysis, and information online. However, ample access also leads to difficulty in navigating and accessing important metrics.
5. Anchoring and adjustment
Anchoring, similar to an anchor that helps a ship stay docked, also leads an investor to become overly fixated on a particular metric or benchmark. For example, an investor may be unwilling to sell shares bought at a premium because they’re anchored to the buy price, even though the current discounted price reflects the fair value of the share. Similarly, an investor may be anchored to the incorrect analysis of a so-called ‘advisor’. Conservatism bias is a type of anchoring bias where an investor is unwilling to change their existing views even when given new proof.
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