Staying disciplined regardless of market conditions is a skill shared by all talented investors. It is not easy to stay the course during trying times, but anyone can do it.
We all have cognitive biases that can obscure our judgment and influence our reasoning. In general, cognitive biases involve making decisions based on certain beliefs or concepts that may turn out to be incorrect. For example, if several people are in the same section of a store, you might assume that an interesting item is on sale. Your guess might be right, but it might just be a new product that these people are intrigued with.
When it comes to investing, cognitive biases can lead us to make decisions that are not conducive to building long-term wealth. Successful investors can ignore these biases and stick with their approach to investing.
Common cognitive biases
Here are four cognitive biases shared by many investors (even the most experienced). One of the main ways to overcome cognitive investment biases is to recognize the warning signs and make a deliberate effort to avoid them.
This bias arises when a decision is made (or anchored) exclusively based on reasoning that may no longer be valid. For example, you think that a stock you own was bought at “fair value”. Suppose the stock price of this company goes down as it faces more and more competitors and its foundations are weakening. If you stick with your perspective that the business is good and deserves a higher price, you might hold onto that stock for too long, thinking it will come up. Sometimes the price of a stock never goes up.
The ripple effect. One of the most common biases among investors is the ripple effect, also known as the “herd mentality”. People tend to prefer the safety of crowds over the vulnerability of standing out. Many investors do not have the confidence to make independent investment decisions. It is therefore more reassuring for them to take an example from others. It may mean investing in the hottest action of the moment, the “media favorite”. However, when a stock becomes "popular" it may be overvalued and not worth buying. Likewise, if everyone is selling a particular stock, you might be tempted to do so too, whether the reason is good or not. Following the trend can be one of the most difficult biases to overcome.
Confirmation bias. This bias occurs when an investor sees a particular company or industry in a certain way (for example) and seeks information or data to confirm their opinion. In the investment world, this bias is unproductive because it can cause you to ignore information that does not match your perspective. You may be making an ill-informed and misguided investment simply because you preferred to focus only on the information that supports your beliefs.
Aversion to loss. No one likes to lose. In fact, it is commonly believed that we feel much more pain when we lose than we feel pleasure when we win. As an investor, it can be difficult to admit making mistakes that can result in a loss of money. This may encourage you to hold on to your investment in the hope of a recovery. Often the price does not go up. So you took the risk of losing more money in addition to missing out on really good opportunities because your capital was tied up in this losing investment.
The advantage of professional advice
Cognitive biases can prevent an investor from creating meaningful wealth. As an advisor, I understand the possible consequences of skewed investing and can help you stay focused on your long-term goals. If you stay the course and overcome your cognitive biases, you will be able to invest successfully in your financial future.
Contact our office to learn how to achieve your financial goals through a disciplined investment approach.