Where Do Cognitive Biases Come From?
A cognitive bias is a methodical fallacy in the rationale that can cause an investor to make poor choices when making financial decisions. It is a well-known adage in the world of finance that “you are your own worst enemy.” Although people are naturally predisposed to search for easy solutions and steer clear of complexities, taking the path of least resistance when it comes to investing can be extremely risky.
Cognitive biases can make it difficult to make investments in a rational and objective manner. They have the potential to sway your judgment in the financial markets and cause you to make investments that are erroneous from a personal point of view. Because of this, it is essential to gain an awareness of your preconceptions and prejudices in order to ensure that you do not sabotage your progress.
The Impact That Cognitive Biases Have On Trading
Investing is a practice that nearly always comes down to making judgments about what actions to take. However, human beings already possess their very own preexisting belief system, which functions as a compass for their overall decision-making. This is an example of cognitive bias in action.
A shareholder, for instance, may perceive new market data based on what they believe in, curve-fitting it to fit what they expected. In this scenario, the investor is trying to confirm their beliefs. Due to the emotional connection that people have with their financial resources, investment decisions are a highly psychological endeavor. Because of this, it is important to be mindful of cognitive biases and to know how to control your inherent human brain in order to prevent it from working against you in the marketplace.
Examples of Cognitive Biases and a List of Them
When it comes to the definition of confirmation bias, it is the natural human instinct to search for convenient data to facilitate one’s beliefs or conclusions. This is known as the “convenience information fallacy.” In addition to this, there is a tendency to avoid any details that are inconvenient. For example, if you have a bullish bias toward a particular stock, you will seek out opinions and articles that support your bullish bias and will avoid any other information that might imply that the underlying stock may be entering a bearish mode.
When it comes to investing, this can be a very risky move that can cause one to hold on to positions that are losing money. When making an investment in any kind of asset, it is critical to give equal weight to the pros and cons of various points of view, both positive and negative.
The Definition of Hindsight Bias
The tendency to presume that past positive outcomes were the result of one’s understanding and ability to determine what the market will do in the future is an example of hindsight bias. Another aspect of this mindset is the conviction that unforeseeable circumstances are to blame for unfavorable outcomes. For instance, if an investor has a string of successful investments, he or she might draw the conclusion that “he knew it all along.” This is a very risky mentality because it can lead an investor to believe that investing is a very straightforward endeavor. It also has the potential to convince investors to take risks they don’t need to take because they believe they “know what the industry will do.”
The Recency Bias
The propensity to give more value to recent information in comparison to information that is much older is referred to as recency bias. The belief is that the information that is currently available has the potential to affect the future more than the information that is older, which is normally regarded to be irrelevant.
For instance, if you have a position on a specific stock, you can give more credence to a relatively positive change in management while conveniently ignoring the fact that the business missed its quarterly report by a significant margin during the most recent quarter. This allows you to maximize your potential return on the stock. When making financial decisions, it is essential to give careful consideration to all of the relevant information at your disposal, regardless of how recent or how dated it may be.
The Very Popular Herd Mentality
Herd mentality bias is to copy or follow the “crowd” at the cost of one’s own independent study and ideas. This tendency is also recognized as the Bandwagon effect. Those who are susceptible to this bias find comfort in holding positions that are shared by other investors. This bias has been liable for many instances of price bubbles, which ultimately lead to the financial ruin of many investors. For example, in the year 2021, there was a lot of excitement surrounding dogecoin.
The majority of investors rushed to buy it due to the “fear of missing out,” but they found themselves in a difficult position after prices dropped significantly. It can be difficult to avoid going with the “crowd” when everyone else seems to be jumping on a certain investment opportunity, but doing so is not always the smartest choice.
The Bias Toward Avoiding Losses
It is inherent human nature to try to avoid making a loss. Those who are susceptible to the loss aversion bias tend to be more concerned with avoiding losses than they are with pursuing gains. This bias can work against investors since it makes it difficult for them to accurately measure the opportunity cost of their investments.
For example, suppose you have invested in stock A, which is presently down by fifty percent, but you are reluctant to reduce your losses to take advantage of an opportunity with a high probability in stock B. Investing is a game of risk versus returns, and investors should always be eager to obtain rewards while also being prepared to accept losses from time to time. However, investors should never be eager to lose money.
The Fallacy of the Narrative
The narrative fallacy refers to investors being enticed to make investments in ‘good stories,’ while overlooking investment alternatives deemed to have rather ‘bad stories.’ When it comes to the stock market, investors tend to go for risky growth stocks while overlooking the real worth of stock in well-established companies. For example, an investor may be attracted to the company’s stock that wants to wander into trendy areas such as cannabis and cryptocurrencies, while overlooking the secure stocks of historical companies that have a reliable track record. This can cause the investor to miss out on potential returns.
Status Quo Bias
This is to avoid making decisions that could potentially change the existing scenario of investment is known as status quo bias. A desire for things to continue, in the same manner, is an irrational one. Investors who are affected by this bias are resistant to changing their minds, even when facts or information is presented to them that suggests doing so would be beneficial. For example, an investor who thinks that stock A is in a long-term uptrend will disregard any price drops in the short term as being nothing more than “noise” rather than an indication of a genuine shift in the trend.
Blind Spot Bias
This is the ability to recognize biases in other people’s opinions or beliefs while failing to acknowledge one’s own biases is known as blind spot bias. Blind spot bias can occur in both individuals and groups. Investors who are susceptible to this type of bias have a convenient tendency to avoid seeing their own “blind spots.” This is a very risky behavior because it makes shareholders very resistant to impartial opinions or views regarding a specific investment.
Overcoming Prejudices in Commercial Trading
It is critical to have an awareness of the fact that, as human beings, each of us possesses some type of implicit bias. Investors can get a head start on the path to making choices in the market that are continuously objective if they first gain this awareness. The effects of biases can be remedied, but the biases themselves cannot be treated.
Building a robust trading plan that outlines your trading plan, risk mitigation, and trading psychology are one of the most effective ways to go about accomplishing this goal. It is critical to maintaining a rigid adherence to the strategy while retaining the ability to adapt it in response to shifting market conditions or new information that becomes available. Having a trading plan that is based on rules will help you make consistent decisions regarding your investments while protecting you from the risk of falling victim to subjective biases.
“Think about your thoughts” is one of the most significant factors that influence the success of your activities related to investing, and it is one of the many factors that can influence the success of your activities related to investing. Recognizing your prejudices and dictating their impacts can provide you with the psychological advantage that is required to carry out successful activities related to investing.