Question

How does psychological biases lead to poor investment decisions. How will these practices improve investment decisions?  

minimum 150 words

Answer 1

Investment biases are of two categories. They are Cognitive investing biases and Emotional investing biases. Cognitive investing biases involve information processing or memory errors, whereas emotional investing biases involve taking actions based on feelings rather than on facts.

Some of the psychological biases that lead to poor investment decisions and remedies to avoid them are as following:

1. Overconfidence
   Overconfidence has two components: overconfidence in the quality of your information, and your ability to act on said information at the right time for maximum gain. Studies show that overconfident traders trade more frequently and fail to appropriately diversify their portfolio.

   How to Avoid This Bias
   Trade less and invest more. Understand that by entering into trading activities you're trading against computers, institutional investors and others around the world with better data and more experience than you. The odds are overwhelmingly in their favor. By increasing your time frame, mirroring indexes and taking advantage of dividends, you will likely build wealth over time. Resist the urge to believe that your information and intuition is better than others in the market.

2. Reducing Regret
   Admit it, you've done this at least once. You were confident that a certain stock was value priced and had very little downside potential. You put the trade on but it slowly worked against you. Still feeling like you were right, you didn't sell when the loss was small. You let it go because no loss is a loss as long as you don't sell the position. It continued to go against you but you didn't sell until the stock lost a majority of its value.

   How to Avoid This Bias
   Set trading rules that never change. For example, if a stock trade loses 7% of its value, exit the position. If the stock rises above a certain level, set a trailing stop that will lock in gains if the trade loses a certain amount of gains. Make these levels unbreakable rules and don't trade on emotion.

3. Limited Attention Span
   There are thousands of stocks to choose from but the individual investor has neither the time nor the desire to research each. Humans are constrained by what economist and psychologist Herbert Simon called, "bounded rationality." This theory states that a human will make decisions based on the limited knowledge they can accumulate. Instead of making the most efficient decision, they'll make the most satisfactory decision.

   How to Avoid This Bias
   Recognize that the media has an effect on your trading activities. Learning to research and evaluate stocks that are both well-known and "off the beaten path" might reveal lucrative trades that you would have never found if you waited for it to come to you. Don't let media noise impact your decisions. Instead, use the media as one data point among many.

4. Chasing Trends
   This is arguably the strongest trading bias. Researchers on behavioral finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year. Although financial products often include the disclaimer that "past performance is not indicative of future results," retail traders still believe they can predict the future by studying the past.

   How to Avoid This Bias
   If you find a trend, it's likely that the market identified and exploited it long before you. You run the risk of buying at the highs - a trade put on just in time to watch the stock retreat in value. If you want to exploit an inefficiency, take the Warren Buffett approach; buy when others are fearful and sell when they're confident. Following the herd rarely produces large-scale gains.