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Investing can be frustrating, can’t it? You can read a hundred articles and a dozen books on investing; for some reason, your investment returns still refuse to improve. To make matters worse, sometimes an ordinary Joe with no background in finance will come along and outperform you! In fact, they may, for a while, even outperform experts in the field. Why might that be?
Well, unlike other fields of expertise, you can argue that education, experience, resources and connections, while still vitally important, come secondary. The most important factor in investing is psychology and behaviour, which is why the topic of behavioural finance even exists! You can have all the knowledge in the world, but if you’re not aware of and in control of your investing psychology, you will be prone to biases, emotional decisions or irrational assumptions.
As we get more experienced with investing, we start forming our own opinions and biases about the financial markets. Based on preconceived notions that may not be entirely true, bias can greatly hinder your decision-making. Remember, we’re dealing with financial markets here; they are sometimes volatile and always unpredictable. Having strong biases may deter you from doing proper analysis and research due to overconfidence.
So, it is extremely important to be aware of your biases. Here are some common ones that many, many investors have:
Representative bias refers to the thinking that every similar trade will lead to the same outcome. This bias may compel you to try and replicate trades that have been successful in the past without carrying out proper analysis/research on the current market conditions or financial instruments. Granted, markets may follow certain price or volume patterns, sometimes due to market behaviour, but this is bound to change without prior notice. As we’ve said, the market is unpredictable. Hence, you should approach each new trade with due diligence, treating it separately from past trades while at the same time learning from experience.
This bias isn’t limited to just trading; it can affect our assumptions and analysis of all sorts of things. For example, there’s a common investing error in connecting good products with the manufacturer. It is not necessarily the case that good products mean the manufacturer is a good company or that shares of a good company are necessarily a good investment (at any price).
Sometimes, our strategies and trading plans may fail. That does not mean that the strategy is complete without merit, though. Nobody, not even the world’s greatest investor, can avoid making some (or even many) trades that go wrong!
Negativity bias may compel you to only focus on the flaws of the strategy and not recognise the positives. Due to this bias, you may never truly learn what works. The reasoning is that you’re blinded from the positives of any flawed strategy until you find a strategy that is 100% foolproof (which doesn’t exist). As such, investors need to holistically analyse their strategy to find out what went wrong and what went right. By understanding what went wrong and right, investors can tweak their strategy to make it work instead of starting from scratch every single time.
The endowment effect refers to the irrational overvaluing of objects that one owns. This bias often occurs with things that have an emotional or symbolic significance to the owner. This includes purchasing financial instruments bought as an investment, causing the owner to perceive its value at above the market price. Just the mere possession of the object may be enough to trigger the endowment effect.
The two main triggers of the endowment effect are:
This bias refers to seeking out and giving greater importance to news and information that fits your current viewpoint. The information available on the Internet may be contradictory, and it may be difficult to determine what’s right or wrong. However, we don’t believe that things are always black and white; there is always insight to be gained. We urge investors not to disregard news and information that may contradict their current beliefs and understandings of the market. Instead, read it critically and ponder why those opposing views exist to get a more holistic perspective.
On the flip side, news and information contradict your current viewpoint and could lead to cognitive dissonance. Cognitive dissonance comes from believing in two contradictory things simultaneously, resulting in confusion and possibly anxiety. Ultimately, this leads to irrational decision-making.
The Gambler’s fallacy is a tricky one. It refers to investors believing that a particular event is more likely to happen due to past events. For example, if I toss a coin ten times, one might think that it’s likely to finally land on heads after landing on tails the first 9 times. That is untrue. The probability will always be 50/50.
The word “gambler” is worth noting in the gambler’s fallacy. The distinction between investing, speculative trading and gambling may not be so clear-cut because luck plays a significant role in all three. Speculative trading and gambling also exhibit significant overlaps around addiction.
"The conceptual and empirical relationship between gambling, investing, and speculation" in the Journal of Behavioral Addictions (Arthur, Williams, Delfabbro, 2016)
Luck is impossible to quantify, and it’s sometimes rude to suggest the amount of luck involved in people’s successes. The fact of the matter is: luck plays a huge role in investing. There are so many factors that affect the prices of our financial assets. At the end of the day, supply and demand determine market prices. We can do our due diligence, study market behaviour and be up to date on the news. Ultimately, it’s all to predict what the millions of other investors will do. We’re never 100% correct.
It’s not just market and company information that affects an investor’s decision. Other factors affect it, such as when the investor is available to make trades, the positions they currently have open, how those positions are performing, whether any life circumstances are giving them stress, whether they are sick and can’t make proper decisions, etc. So many things affect the millions of investors worldwide that play a part in determining market prices. Institutional investors (index funds included) may be hit with inflows or outflows which are unrelated to the companies they hold in their portfolios. Also, hedge funds may run massively leveraged positions in derivatives that drive seemingly wild market participant activity. You can’t predict every detail.
Don’t underestimate the role that luck plays in your success. Keeping the impact of luck in our minds will keep us humble and prevent us from getting overconfident. Of course, don’t overestimate its part in your failures as well. Doing our due diligence, analysis and research go a long way in predicting where the market will swing (even if it won’t always be right). As they say, "the harder you work, the luckier you get"!
What exactly do traders with gambling-related addictions exhibit? They may feel compelled to perform trades throughout the day, be preoccupied with thinking about trading while doing other things, increasing the amount of money used in trading or taking on increasing levels of risk. At the end of the day, gambling disorders may lead to a significant monetary loss, especially because irrational decisions involve large sums of money.
In fact, most addicted traders tend to follow the same pattern: experience early wins, gain confidence → experience losses and hence increase investment amounts in hopes of recouping losses → losing control and losing a large sum of money.
Ask yourself some of these questions:
If you’re unsure if your trading habits exhibit any of the above biases, do get a second opinion on it. It is hard to get a clear view of your habits when you’re so close to them.
COMMON BIASES TO AVOID. COMPLETED. ✅
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