Five Cognitive Biases that Hurt Investors & Traders the Most
What is a Cognitive Bias?
Humans tend to think in certain ways that can lead to systematic deviations from making rational judgments.
These tendencies usually arise from:
Information processing shortcuts
The limited processing ability of the brain
Emotional and moral motivations
Distortions in storing and retrieving memories
Cognitive biases have been studied for decades by academics in the fields of cognitive science, social psychology, and behavioral economics, but they are especially relevant in today’s information-packed world. They influence the way we think and act, and such irrational mental shortcuts can lead to all kinds of problems in entrepreneurship, investing, or management.
The following five cognitive biases, for full list go to bottom of post, seems to hurt traders the most. Be aware of them, understand them and avoid them.
The first piece of information you see or hear often ends up being an “anchor” for others that follow.
As an example, if you heard that a new stock was trading at $5.00 – that is the piece of information you may reference whenever thinking about that stock in the future. To avoid this mental mistake: analyze historical data, but don’t hold historical conclusions.
Recency bias is a tendency to overvalue the latest information available.
If you heard that a CEO is resigning from a company you own shares of, your impulse may be to overvalue this recent news and sell the stock. However, you should be careful, and instead focus on long-term trends and experience to come up with a more measured course of action.
Loss Aversion Bias
No one wants to lose money, but small losses happen all the time even for the best investors – especially on paper.
Loss aversion bias is a tendency to feel the effects of these losses more than wins of equal magnitude, and it can often result in a sub-optimal shift in investing strategy. Investors that are focused only on avoiding losses will miss out on big opportunities for gains.
Taking in information only that confirms your beliefs can be disastrous. It’s tempting, because it is satisfying to see your previous conviction in a positive light – however, it also makes it possible to miss important findings that may help to change your conviction.
No one wants to get left out, but being the last one to pile onto an opportunity can also be cataclysmic. If you’re going to be a bandwagon jumper, make sure you’re doing it for the right reasons.
Every Single Cognitive Bias in One Infographic
The human brain is capable of incredible things, but it’s also extremely flawed at times.
Science has shown that we tend to make all sorts of mental mistakes, called “cognitive biases”, that can affect both our thinking and actions. These biases can lead to us extrapolating information from the wrong sources, seeking to confirm existing beliefs, or failing to remember events the way they actually happened!
To be sure, this is all part of being human – but such cognitive biases can also have a profound effect on our endeavors, investments, and life in general. For this reason, below infographic from DesignHacks.co is particularly handy. It shows and groups each of the 188 known confirmation biases in existence.
Thanks to VisualCapitalist.com for their posts and beautiful infographics.