What causes most investors to fail is psychology, so you need to be prepared. Here are nine of the most common hiccups your brain is likely to encounter.
Confirmation bias: Once we form an opinion we tend to search for and interpret information in a way that is consistent with it. When investing, confirmation bias can lead to overconfidence.
Solution: Imagine that your investment has collapsed and ask yourself how and why it might have failed.
Bandwagon effect: The tendency to believe or do something simply because a large group of others believe or are doing the same. This leads to herd behavior in the stock market.
Solution: When you notice your beliefs conform to a large group, play devil’s advocate for a moment and consider what the best counter arguments might be.
Availability heuristic: The tendency to overestimate the likelihood of events that can be easily recalled.
Solution: When considering an investment, focus on the company’s long-term history, not just recent media coverage.
Hyperbolic discounting: The tendency to favour an immediate payoff rather than a distant, more advantageous benefit. This is one of the most limiting biases when it comes to investing and saving.
Solution: Constantly ask yourself ‘In ten years’ time, what decision will I wish I had made today?’
Normalcy bias: The tendency for people to underestimate the probability of a disaster that hasn’t happened before and, consequently, to fail to prepare for it.
Solution: When investing, try to think through a worst-case scenario, how it might be caused and how you should prepare. Be wary of thinking ‘if it hasn’t happened before, it can’t happen’.
Self-serving bias: The tendency for people to feel responsible for successes but blame failures on external factors.
Solution: Failures are inevitable in investing. Take pride in them and use them to learn and adapt. When you blame failure on circumstance, you forgo the opportunity to improve.
Loss aversion: Our tendency to strongly prefer avoiding a loss to making a gain of equal size. It can cause us to sell irrationally to avoid further losses, even if an asset is a wise long-term investment.
Solution: Loss aversion is deeply wired into all of us. The best way to combat this bias is to distance yourself psychologically from the potential loss. Imagine that it was not you but a friend in the situation, what advice would you give them?
Endowment effect: Where we ascribe more value to things merely because we own them. We demand higher compensation to give up an object than we would pay to acquire it.
Solution: It’s easy to get attached to the stocks we own, especially those that have done well. Set the valuation criteria you require to sell a stock before you buy it, and only move the goal posts for fundamental changes in your investment case, not merely changes in share price.
Ostrich effect: Avoiding confrontation with a negative situation by pretending it doesn’t exist. Studies have shown that investors check the value of their investments less during bear markets.
Solution: Commit to checking your investments periodically and, for those showing substantial losses, determine whether the long-term investment case has changed fundamentally or if the current loss is likely to be temporary.
To learn more about investor biases and heuristics, see Part 2.