Years in finance have taught me it’s common practice to see individuals consistently make the same investing mistakes. I include myself within that group, as we are all guilty of biases that we don’t notice or appreciate. We are, after all, human.
We like to see ourselves as rational beings. Unfortunately, we’re not – we take risks that we shouldn’t, chasing rewards that we needn’t. But this trait is natural and it’s something we have to accept and manage through increased awareness and applying various strategies.
So here are two biases a few of us are guilty of, which also manifest themselves in other areas of life:
Bandwagon Effect
We all appreciate the concept of ‘jumping on the bandwagon’, but going along with the crowd isn’t always the best thing for investors. Those that bought at the peak of the dotcom boom will have something to say. And anyone that timed it wrong during the property bubble will vouch for that. It didn’t mean that you couldn’t make money in the boom. It’s just that the risks of it not working out also increased dramatically with time.
World-renowned investor Warren Buffett once gave the famous advice to be greedy when others are fearful and fearful when others are greedy. He essentially suggested we should not get sucked in by the bandwagon. Investors may well feel better when they are investing along with the crowd. But research has shown that over the longer term going with the herd doesn’t always end up being as profitable, particularly if you get caught with a bubble bursting.
Loss-Aversion Bias
One of the strongest biases that we have is that of loss aversion. Essentially, we dislike the idea of losing more than we like the idea of winning. It applies to a lot of areas in life and is certainly very apt with your personal finances. Research has shown that people tend to get more upset at the idea of losing $10 than they do at finding $10.
There will be times when you’re holding a stock in your portfolio that has fallen so much that you can’t stomach the idea of selling. In that situation, you should probably sell the stock and reinvest the proceeds into something with a better future. After all, that stock may never recover and it could be dead money. But that would be rational, and we don’t always act rational.
The Outcome
Being aware of these biases and acting upon them are two entirely different things. By becoming aware we can at least start to learn how to manage the way we think, allowing us to hopefully make healthier choices.