Mastering the Mind: 5 Behavioral Biases in Investing

Humans are emotional in nature, and while it's nearly impossible to be completely free of biases, recognising and mitigating them is crucial for making optimal investment decisions.

1. Confirmation Bias

When a stock you've invested in appreciates in value, it doesn't necessarily validate your investment decision. Similar to golf, where a poor shot can fortuitously land in a perfect spot, stock movements can be equally random and misleading. Distinguishing between a fluke and a sound decision is essential. Analyse the reasons behind the stock's performance and consider external factors that may have influenced the outcome rather than attributing it solely to a wise choice.

2. Herding Bias

This bias occurs when investors follow the crowd into popular stocks or sectors without sufficient analysis. The fear of missing out (FOMO) can drive investors to make decisions based on market trends rather than solid data. It's important to conduct independent research and make investment decisions based on your findings and risk tolerance, rather than being swayed by the prevailing market sentiments.

GameStop is a perfect example of this, becoming the centre of a massive investment frenzy driven by a group of retail investors from r/WSB. The catalyst was the collective action of individual traders using social media to initiate a short squeeze against institutional investors who heavily shorted GME stock. This would have been a good trade at the time if you had access to the information early, however, many people piled in near peaks in fear of missing out on easy profits. Ultimately, the high share price was unsustainable fundamentally and faced a massive decline.

3. Anchoring Bias

Anchoring occurs when investors hold on to initial beliefs and fail to adjust to new, relevant information. This can lead to missed opportunities for adjustment or correction in investment strategy. To combat this, actively seek out diverse viewpoints and new data, and be willing to adapt your investment stance when the evidence supports a change. A key investment thesis for a buy on a given stock may change if certain events occur and its important to realise this and be flexible in your opinions/not be anchored to the original thesis.

A clear example is with Intel stock. People invested in Intel influenced by the company's dominance in the CPU market prior to 2020. This was a valid reason at the time, however significant catalysts occurred when AMD released its Ryzen series, which outperformed Intel's offerings in benchmarks, shifting the entire competitive landscape. This reason may not be enough for investors to sell Intel stock, however in July 2020, Intel announced a delay in the development of 7nm chips, a key technological step that was already completed by competitors like AMD. This news caused Intel's price to drop, however many investors held on, anchored to their initial buy rational and Intel's past market position. We can see here that Intel's competitive positioning has been weak, and has underperformed relative to the tech sector. Thus, we learn to re-evaluate a stock's position in light of new information coming out and not anchoring to stale information.

4. Hindsight Bias

This bias leads investors to believe, after an event has occurred, that they had predicted the event beforehand. It can create overconfidence in one's predictive abilities and skew risk assessment. To counteract hindsight bias, I keep an investment journal that records my predictions and the rationale behind them at the time of decision-making. This can provide a more accurate reflection and learning tool.

5. Loss Aversion

Many investors hesitate to close positions at a loss, driven by an emotional response rather than a rational assessment of the situation. If the original rationale for an investment no longer holds due to new information or market changes, it is prudent to cut losses and reallocate resources to more promising opportunities. Developing a disciplined investment strategy that includes predefined exit rules can help manage emotional responses to losses.

Similarly, the Intel case is another good example of investors' natural emotional instinct at loss aversion.

Conclusion

Overcoming these biases is not about suppressing emotions but about acknowledging them and ensuring they don't cloud your judgement. Incorporating systematic analytical processes, continuous learning, and reflection can help mitigate the impact of these biases. By understanding and adjusting for these behavioural tendencies, investors can improve their decision-making process and ultimately enhance their investment outcomes.

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