The Top Seven Biases Any Investor Should be Aware | Smart Investing 101

Investing is not rocket science” as Billionaire Warren Buffet puts it. Therefore, what is that makes investing so hard? Many great investors agree on the fact that our brain works against us. But what are the main biases in which the speculator falls in? Here a list of the most common ones:

  • Intuition Index: Do you know that your intuitive machine works better when in a good mood? Daniel Kahneman in some of his experiments showed that people who were put in a good mood doubled their inherent ability. The opposite is true as well. Many mistakes made by speculators happen either when in an exuberant mood or in a terrible mood.
  • The Illusion of Pattern: Everything around us has a meaning. Isn’t it so? Way less than you think. Ever since Greek Philosophers (Plato and Aristotle more than anyone) thought us about purpose. Everything in nature must have a purpose and therefore be connected by a cause-effect relationship.cause-effect relationship. Our tendency to look for patterns is in part built-in and in part inherited from ancient philosophy. We love order, it makes us feel safe, and it gives us a sense of self-confidence. The problem is that we go too far with our tendency to look for order. We see patterns where they are non-existent. The investor falls in the same cognitive bias often. In many circumstances, he attributes the rise or fall of stocks to the next market news.
  • Anchoring Effect:  When someone gives us a certain number (not necessarily related to the transaction) for some reason we stick to that figure (or we don’t go too far from it). For example, if I were to ask you the age when an individual person died, and before the question, you were showed a small number (say 25) chances are you will say the person died at a young age. The investor falls into the same trap when dealing with stock price. For such reason, stocks, which tend to be overpriced by the market, are also the most desired. The opposite is true as well.
  • Outcome Bias: Success is a matter of results, isn’t it? We often tend to listen to “successful people,” almost like the outcome of their success is mainly due to their ability to make good decisions. If this can be true in some cases, it can also be incredibly wrong in many other cases. On the other hand, we are inclined to accuse those, which sound decisions didn’t turn out to be also the right ones because of the outcome. The speculator often associates a winning strategy based on its results. The problem lies in the fact that the strategy may have worked out of pure lack. Therefore, once the speculator gets convinced of how sounding the strategy is that is when disasters happen.
  • Theory-induced blindness: “This is just an idea! It isn’t real!” How do you feel about this statement? Although your System 2 may rationally agree, your System 1 seems not to grasp this concept. Indeed, we treat ideas like belongings. We own them, we breathe them, and we would perish or murder for them. Wouldn’t we? How otherwise can we explain wars fought for religion, power and so on? Wasn’t Descartes who once said, “Cogito Ergo Sum” (I think therefore I am)? We feel alive when we theorize and make sense of the world around us. This isn’t negative in itself. What is negative is the fact that we get devoted to those theories. Many times the investors, which fall in love with their ideas, are the ones who wind up losing money. A different example of that is investor George Soros. Soros has the ability to change opinion very quickly. In other words, if changing view can be seen poorly in politics or any other field, this does not apply to investing. The screwed investor has to be ready to change “idea” very quickly.
  • Loss aversion: Losses loom larger than gains.  The “loss aversion ratio” has been estimated in several experiments and is usually in the range of 1.5 to 2.5,” says psychologist Daniel Kahneman. The speculator often falls into the trap of opening positions, to recoup the losses or waiting too long before liquidating a losing position, because of the deceiving thought of waiting for the stock to rise again.
  • Domain Dependence: formulated by Nicholas Nassim Taleb in “Antifragile,” this is a fascinating concept. It consists on the inability of individuals to transfer the knowledge they have in one field to another area. For instance, investors, often make decisions about market moves based on mere superstition. Although, they are “experts” and as such should be able to transfer their financial knowledge to the financial markets, often they are not able to do so.

 

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Published by

Gennaro Cuofano

Gennaro Cuofano, International MBA. Creator of The Four-Week MBA Community and Content Marketer/Business Developer at WordLift