A common trait of successful investors is their ability to stay disciplined in all market conditions. Remaining focused in adverse times isn’t easy, but everyone can do it.
We all have cognitive biases that may cloud judgement and influence reasoning. Cognitive biases typically involve arriving at decisions based on certain concepts or beliefs that might not be accurate. For instance, if people in a store are clustered around one area, you may assume something good is on sale. Your assumption may be correct, but perhaps it’s just a new product that people are curious to see.
When it comes to investing, cognitive biases may move you to make decisions that are not conducive to building long-term wealth. Successful investors can block out these biases and stay true to their investment approach.
Common cognitive biases
Here are four cognitive biases that many investors – even experienced ones – display. A key to overcoming investing with cognitive bias is to recognize the signs early and make a conscious effort to avoid this bias.
Anchoring. This bias occurs when a decision is based (or “anchored”) exclusively on a line of reasoning that may no longer be valid. For example, you believe a stock you own was purchased at a price that represented “fair value.” Let’s say this company faces increased competition and has weakening fundamentals, and its stock price declines as a result. If you remain anchored in your belief that the company is attractive and worthy of a higher stock price, you may continue to hold the stock too long, assuming it will rebound. Sometimes the stock price never recovers.
Bandwagon effect. Also known as “herding” or “herd mentality,” it’s one of the most common investing biases. People usually prefer the safety of crowds rather than standing out and being vulnerable. Many investors lack the confidence to make independent investment decisions, so it’s comforting to follow what everyone else is doing. It could be investing in today’s hot stock that is a “media darling.” However, by the time a stock becomes “hot,” it may be overvalued and not worth buying. Similarly, if everyone is selling a stock, you might be tempted to do likewise – whether there is good rationale or not. Following the crowd can be one of the toughest biases to overcome.
Confirmation bias. This bias occurs when an investor holds a certain view about (for example) a given company or industry, and then seeks information or data that will support this view. In investing, this bias is unproductive as it can lead you to ignore information that doesn’t match your pre-conceived view. You may end up making an uninformed, unwise investment simply because you sought the comfort of focusing only on information that confirmed your particular beliefs.
Loss aversion. Nobody likes to lose. In fact, it’s generally believed that people experience much more pain when losing than pleasure when winning. It can be difficult as an investor to admit you’ve made a mistake that may cause you to lose money. This may prompt you to continue holding your investment, hoping it will rebound. Oftentimes the price does not bounce back, so not only have you put yourself at risk of losing more money, but you’ve missed legitimately attractive opportunities because your capital was tied up in this losing investment.
The benefit of professional advice
Cognitive biases can impair an investor’s ability to create meaningful wealth. As an advisor, I understand the potential impact of biased investing and will keep you focused on your long-term goals. If you “stay the course” and overcome cognitive biases, you can invest successfully for your financial future.
Contact our office to discuss how disciplined investing may help you achieve your financial goals.