What are Investors’ Most Dangerous Unconscious Biases?
Investor Biases make stock markets inefficient and cause mispricing of assets. And also, they provide opportunities to investors who can deal with them.
Anchoring Effect of the Market Price:
Our mind is biased by the first impression. Usually, investors start to analyze a certain stock with looking at its price which will unconsciously be anchored to the value of the stock.
An interviewer asked Warren Buffet how he found a stock like PetroChina and he responded: “I sat there in my office and I read an annual report, which fortunately, was in English and it described a very good company. It talked about the oil reserves, talked about the refining, and talked about the chemical and everything else. I sat there and read it, and thought to myself ‘this company’s worth about 100-billion’. Now, I didn’t look at the price first. I look at the business first and try to figure out what it’s worth because if I look at the price first I’ll be influenced by that. I look at the company first. I try to value it. Then I look at the price and if the price is way less than what I’ve just valued it at, I’m going to buy it.”
Confirmation of Already Made Investment Decisions:
Once we made an investment decision and invested our hard earned money in a stock then, we seek the evidence that confirms our decision and filter the information contrary to our opinions. So, investors need to be trained in critical thinking and be open-minded to contrary views.
If investors make profits by chance they tend to think the “success” comes from their personal skills. In this case, attribution bias works with confirmation bias explained above. But if they lose a considerable amount of money in the market then they tend to blame others but not their lack of risk management or their greed.
In a bull market, making money is not difficult. When the stock prices rise the investors get overconfident and take more risks which result in more return but only until a Baer market suddenly hits. And then, they blame the game and tend to believe in conspiracy theories.
This is very sneaky and harmful bias which is believing that the past events could be reasonably predicted whereas they couldn’t. In retrospect, all events appear more predictable than they are. For example, novice traders usually risk too much because, in retrospect, price movements show a very obvious pattern. Because of this illusion, they fail and the majority of them leave the trading. And when the investors miss an opportunity then, they tend to think it was very obvious for example, the company was successful and successful companies “always” recover; in this case, the investor will eventually lose money because he invests in a company that was successful in past and could not recover.
After the investors miss an opportunity, they tend to think the opportunity was very obvious to recognize and they regret it. For example, an investor with a hindsight bias misses an opportunity to invest in a company which recovered from a temporary price decline. He would think: the company was successful in the past and successful companies “always” recover, it was very obvious that the company will recover. Next time, he will lose money because he will invest in a company that was successful in the past and can not manage to recover.
The four unconscious biases explained above are always working in combination with other biases. The investors can protect themselves with critical thinking which contains seeking the contrarian opinions, critics etc. and a portfolio strategy with a good risk management.