Four behavioural biases you need to avoid when investing in the stock market
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By Wian van Wyk
When it comes to decisions about investing your hard-earned money, there’s probably nothing more challenging than trying to keep emotions out of the equation.
In fact, most investment portfolios suffer the effects of emotional investing at least once in their existence.
No one is immune to the effect of emotions when investing. When picking stocks, the number one goal is to evaluate your options as objectively as possible.
But, regardless of how disciplined you are, there is always the possibility that your perception of a particular stock’s potential is being tainted by some bias. Whether you are cautious or a risk-taker by nature, have strong opinions of a particular industry, or you are simply having a difficult day, your experiences inevitably create biases that influence your stock decisions.
The best strategy is to educate yourself on the most common biases and to find ways of working around the types that most reflect your stance, he says.
In essence, Van Wyk believes there are four major biases around investing, and the vast majority of people are subject to at least one, if not more of these, to some degree.
Bias #1: Herd mentality
Just because most of the market is following an investment trend, it doesn’t mean it is the right choice for you. Stocks can fall in and out of favour with investors for many reasons.
While certain assets or asset classes see a sudden spike in investments from time to time, they rarely maintain this level of growth. Combating this bias requires that an investor put a little extra time into finding out why certain stocks are seeing surges in activity. If the stock price is being influenced by news or social media, consider whether it will still be relevant in five or ten years time. Simply put, don’t buy into the crowd’s behaviour for the sake of it.
Bias #2: Familiarity can set your growth back
People tend to feel safe with the familiar, but from an investing perspective, this can be a dangerous way of thinking. Investors who crave familiarity tend to concentrate too much on investment opportunities within their own industry or country’s borders.
This could lead to you missing chances to grow your portfolio by taking on offshore assets or diversifying into new spaces. It also might leave you stuck in a cycle of poor returns. Combating this bias requires that you take a hard look at your investment history. Is your investment portfolio too heavily reliant on one industry or region? Ask yourself how to balance your investments more effectively and get information from experts to create a rounded portfolio.
Bias #3: Over-confidence
One of the biggest traps in investing is to become too confident following a winning streak of good stock picks. As soon as short-term success goes to your head, you can easily start to believe that your knowledge is more accurate than it really is.
Sooner or later, this will end badly when you start to trade too much and take too much risk. It may also cause you to anchor the value of an investment to the value it once had, meaning you won’t know when to give up on a bad thing.
The key to combating this is humility. Be realistic about where you were lucky and where you have been acting on good information. Lastly, if you have a balanced strategy from the outset, don’t change anything based on a lucky streak.
Bias #4: Attachment bias
Attachment bias happens when you become emotionally connected to one or more of your holdings. Often, this causes you to hold on to stocks and bonds for too long, despite new information about the asset that warrants otherwise. A good mantra to remember to overcome this is that your portfolio won’t ‘love you back’! Always try to be as clinical as possible when reviewing your portfolio, and remember that you do not owe loyalty to any company or asset class.
Investing is a long and slow journey. By contrast, emotion and biases do not last or lead to clear long-term decision making. Be prepared for the ups and downs, even when they test your resolve. Above all, remember to be aware of the biases that influence your choices daily – and have a plan to combat them.
Wian van Wyk is a Portfolio Manager at Momentum Securities.