5 biases that can make you a terrible investor

5 investing biases

 

We all have cognitive biases in our lives – an inclination to give a preference to something or someone. Biases distort our thinking and often result in us making poor and ill-informed decisions. Very often we’re not even aware we have them! Worst of all, these biases can lead to very bad investment choices.

At Clover, we’re all about helping you make smart investment decisions. So, here are 5 common biases to watch out for while you’re investing.

Bias #1 – Self-serving bias

What is it?

The tendency to attribute your successes to internal factors and your failure to external factors.

How does it affect investing?

It’s natural for us to want to give ourselves credit for positive results. ‘My portfolio went up because I’m an awesome investor.’

Conversely, we’ll blame failures to external factors beyond our control. ‘My portfolio crashed because all the companies I invested in were run by morons.’

This type of thinking is flawed – we’re not saying that all success and failure is completely random. But we tend to think we’re better investors than the reality, and we underestimate the impact stuff like global events, government policy, etc. have on our investments.

Like many things in life, investing is impacted by both internal and external events. It’s the latter that we have less control over and that’s why it’s important to follow some simple rules for investing and stick to them. Do that, and you’ll be less susceptible to factors outside of your control.

Bias #2 – Gambler’s fallacy

What is it?

The tendency to think that the probability of something occurring in the future is altered by past events, when the truth is that those events have no impact whatsoever.

How does it affect investing?

Have you ever heard ‘The market has been going up for the past five years, so it’s due to crash’?

Markets are unpredictable in the short term – they rise and fall like a roller coaster. Just because sharemarkets have been going up for five years doesn’t mean they are due for a downturn.

Over the long term, there is a tendency for markets to be more predictable, but this isn’t true in the shorter term. That’s why we say it’s virtually impossible to time the market. Instead, make sure you’ve diversified your investments so you can ride the market highs and lows.

Bias # 3 – Bandwagon effect (also known as herd mentality)

What is it?

A tendency to take a particular action because lots of other people are taking the same action.

How does it affect investing?

It often leads to unfounded speculation – one of the most effective ways to invest your money poorly.

The bandwagon effect has been demonstrated many times over history. From ‘tulip mania’ in the 17th century to cryptocurrency in the 21st, people have experienced the bandwagon effect when investing and the result is almost always the same – a huge high followed by a tumultuous crash.

Remember the words of arguably one of the greatest investors in the modern era, Warren Buffet:

‘Be fearful when others are greedy, and greedy when others are fearful.’

Bias # 4 – A bias towards action instead of letting compounding work its magic

What is it?

A tendency to tweak your investments and therefore do more harm than good because you’re not reaping the benefits from compounding.

How does it affect investing?

Because compounding is awesome. But it doesn’t work well if you tweak your portfolios too much.

There will be times when you’ll need to rebalance your portfolio. But remember that all long-term gains are susceptible to volatility. Volatility is normal but it’s when people don’t treat it as such that they often get into trouble.

Our advice is that if you’ve followed the rules of investing and have a good plan, stick to it! Let compounding work its magic and you’ll be better off.

Bias #5 – Confirmation bias

What is it?

A tendency to search for, focus on, or remember information that confirms your beliefs.

How does it affect investing?

Because it means that you’re only open to information that proves you were right, when you should also be open to information that challenges or disproves your beliefs.

Say you have a strong belief that turnip-flavoured donuts will be the next culinary wave of the future (yeah, we know this is a bad idea). So you start looking online to find information that validates your belief that turnip donuts will be a big hit. But because you believe in this idea so strongly, you tend to focus on information that supports your belief and ignore information that counters it.  So you invest in turnip donuts and then…well you can guess what happens.

Our minds are pretty powerful tools. They help us decide right from wrong, and whether or not we should eat that bowl of ramen soup or go for tacos instead. But our minds are also subject to bias, and these biases can lead to bad investment decisions. Be aware of bias in your thinking, follow the five rules of investing, and you’ll be off to a good start to making smart investment choices.

Disclaimer

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