What are Behavioral Biases in Investment?

Suppose someone told you he sold six stocks last week, in which five got profits and one had a loss. What would you say?

At first, you may envy his gains.

But don't forget the amount of money he could have lost might exceed his five profitable sales combined.

We are inclined to rely on rules of thumb and instincts when making judgments and decisions.

After all, why bother hammering out a path when a shortcut is already available?

Shortcuts make life easy, but they may also lead us to dangerous places.

In the case of investing, some shortcuts bring losses.

Such perilous shortcuts are represented by behavioral biases, which consist of cognitive and emotional biases.

They should call for our special attention.

Let's first talk about cognitive biases.

Psychology believes that our behaviors are not directly caused by activating events, but rather by how we perceive these events.

Hence, we may easily fall into cognitive biases, which can be classified into information-processing and belief perseverance biases.

Information-processing biases occur when people process information unreasonably.

For example, when bombarded with information every day, investors are likely to overvalue market noise such as daily price movements and comments.

But it's not a good idea to base medium- or long-term decisions only on such information.

It's like missing the forest for the trees.

Then, what about belief perseverance biases?

Belief perseverance bias describes people's tendency to stick to skewed beliefs.

For example, you may know someone who classifies others as either good or bad.

He may also make arbitrary inferences without collecting enough evidence.

Biases like these make you feel helpless because they seem to be difficult to change.

Similarly, in investing, persevering belief biases can negatively impact your investment.

For example, you may have an illusion of control.

You believe you have control over the return of the stocks you prefer.

So you ignore diversification and go overweight on them, which results in a huge loss.

Actually, psychology holds that cognition can be changed, which also applies to investing.

To be more mature investors, we can work on better understanding and changing our cognitive biases to invest more rationally.

Now let's move on to emotional biases.

They stem from emotion-driven impulses or intuitions.

Investing is about gains and losses, achievements and failures.

For traders, it's almost impossible to avoid emotional distress, even though more experienced traders might be affected less by it.

We may fear making mistakes, fear losing money, fear missing out on profitable opportunities...

Specifically, you may close your position too early to take profits because you're afraid of making mistakes again.

You might also trade too frequently to compensate for your previous loss.

What's more, even positive feelings can bring negative effects.

For example, you might trade too many times or too much if you're overconfident about the market.

Your estimate of the reverse trend might come from the fear of losing money.

In short, some emotions, especially strong ones, might hijack our ability to make reasonable investment decisions.

Compared with cognitive biases, emotional biases are harder to overcome because they derive from the inherent needs deeply embedded in us.

Don't try to fight against them. Or you might fall into a state of overexcitement, facing much more terrible consequences.

What we can do is to identify, understand, and accept them.

Knowing where they come from and how they work might increase our tolerance for them.

In addition, changing our investment environments or processes might reduce their frequency.

This way, at least something will be changed.