The 6 psychological investing biases every trader should know and avoid
The feeling of buying when the market is at a high or selling close to an absolute bottom is something most of us can relate to. The strongest forces driving our decisions as human beings are fear and greed. These primal instincts were vital back in the days when we were hunters living among wild animals on the savannah. But when dealing with finances, these forces work against our interests. Being aware of these psychological investing biases can be of great advantage, and there's an entire research field known as behavioral finance covering these aspects.
How fear and greed affect our decisions
Looking at a stock chart in hindsight, it seems so easy to simply buy low and sell high. But when markets are reaching new lows every week and the media paints a picture of dark clouds and depression, we feel the fear and the urge to sell - not buy - to gain safety and lower our risk exposure. It's always darkest before the dawn, as they say, and quite often it turns out, that when everyone believes the markets can only go down and blood is in the streets, that's where the bottom is. But few people dare to go against their basic fear instinct and buy at this stage.
When markets continue setting new all-time-highs week after week, everything is reversed. If we are not in the market, we feel the fear of missing out. Even if we have already made a small fortune on the way up, we feel the greed and the urge to throw in as much money as we possibly can, to get the most out of the bull market.
Blindly following these basic human instincts make us buy and sell at the worst possible times. This is quite the opposite of the logic most us follow, when we buy more of the items in the supermarket that are on offer and tend to stay away from buying the same items when prices are high. This pattern follows a completely different set of psychological rules.
Now, let's take a look at the most common psychological investing biases that affect our trading decisions.
1. Recency bias
Also referred to as availability bias, the recency bias refers to our tendency to focus more on recent events and value this information as more important than it actually is in the big picture. When Covid broke out in 2020, the media painted a picture of a world going into hibernation, and because of the recent events a lot of people thought that stocks could only continue going down - forgetting about all the positive growth parameters that were not affected by Covid.
The recency bias makes us believe that the recent tendency on the market (either up or down) is always there for good reason and that it's no doubt going to continue. But in reality, it doesn't take an expert's view on a typical stock price chart to realize this is rarely the case.
2. The anchoring effect
Anchoring is what happens when we stick too much to our original perception of something, regardless of all the information we receive that might indicate the perception is not correct.
On financial markets, the psychological anchoring effect may also relate to a certain price of a stock or another investment. If we bought tech stocks at the top of the dotcom bubble, believing the price should be at this level or higher, it may be very hard to realize that our original perception was wrong. This may take a while - and cost a lot.
3. Confirmation bias
As human beings, we like the feeling of confirmation. So at an unconscious level, we prefer to read articles that confirm our own perception over articles that challenge it - ultimately making us even more firm in our original perception, regardless if it's wrong.
The confirmation bias also kicks in when we consult other investors, advisors or friends with the same opinion as our own. We naturally like to be confirmed in our belief, and we seek this confirmation whenever possible - often without being conscious of it. This makes it easier for us to believe that we are right and that people with other opinions are just being stupid.
4. Overconfidence bias
If you ask a broad selection of people to rate their own intelligence, the average of these ratings will typically be above average. People tend to perceive themselves as smarter than average - this is particularly the case for men, who seem to suffer more from this bias than women.
Being overconfident on the stock market typically involves taking too much risk, putting too much money into one stock, or being so sure about the future of a company, that you neglect the information that goes against this perception.
5. Loss aversion
Loss aversion refers to the fact that we often feel the pain of a loss as worse than the comparable happiness of a gain of a similar size. Psychologists have found that the feeling of losing $1.000 is about twice as powerful as the pleasure of accomplishing a gain of the same size. This leads us to be over-protective about small gains and sell to avoid the risk of having them turn into losses. And what's worse: it leads us to hold on to losses as they grow bigger - hoping that they will eventually turn into winners, so we can avoid the painful loss.
6. Herd mentality
The final psychological trading mistake to be aware of is herd mentality. It's natural for us as humans to look at what people surrounding us are doing. In recent years this phenomenon has been extremely common thanks to internet forums and other online platforms for financial discussions. When we read that someone argues that a certain stock is going to skyrocket, and about other traders that jump on the boat, it's easy to believe that they probably did the thorough analysis, so I don't have to. But quite often they didn't do the analysis, and the herd goes down together.
How to avoid the psychological investing biases when trading
It's not easy to go against our human instincts, but one thing we can do is to be conscious of the traps. By always going through this list before you make an investment decision, you will at least not forget about the forces that might affect you.
But the only way to completely avoid psychological traps and investing biases is to strictly follow a trading system. When using a trading system your investment decisions are completely based on numbers and facts. All human emotions are eliminated, and you will not be exposed to any of the biases and mistakes listed in this article.