Investments can be a significant step towards securing your assets with long-term visions for better returns. Decision-making skills are one of the main requisites for every investor. At every stage, investors need to ensure they make the most appropriate choices that are not based on biases. You can manage factors influencing market conditions through in-depth research and close monitoring of the financial markets. But what about the impact of your own cognitive aspects? In order to avoid common investment mistakes and achieve excellence in your financial decisions, identifying and understanding psychological biases like the following is crucial.
Here are a few bias-related decision-making pitfalls to watch out for.
Anchoring Bias
While referring to the existing data or studies, it is essential to ensure we view them in an unbiased and objective manner. Anchoring defines the human tendency to rely heavily on past references or the first information received for subsequent decision-making. For instance, while evaluating a specific share value, investors usually tend to focus heavily on the current and past share prices. Rather than basing your decisions entirely on the price factor, other aspects such as the industry performance and potentially influential events must also be considered.
Anchoring bias can be avoided by seeking external input and trying different perspectives.
Confirmation Bias
Investment decisions need to be highly well-planned as well as rational. Humans often fall for the tendency to seek confirming evidence that is in line with their existing beliefs or point of view. Apart from influencing our choice of where we seek opinions, this psychological bias also impacts how we decipher it. A false sense of understanding based purely on one-sided data can lead to inaccurate investment decisions. Questioning our prevalent decisions or views with facts and perspectives that oppose it can be an effective way to avoid confirmation bias and make a strong and informed investment decision.
By adopting a neutral stance and reconsidering your choice by playing the devil’s advocate, confirmation bias can be overcome.
Overconfidence Bias
The most prevalent of all the human brain’s biases is overconfidence. Three different manifestations of overconfidence bias include overrating, assuming predictive skill, and unrealistocic optimism. Although being firm or confident about a well-planned investment decision is essential, you must also ensure that you have considered all the possibilities during the decision-making process. Overestimating the accuracy of your forecasts can cause errors in the estimation of the results. Financial decisions should be based on analytical and statistical data for efficient risk management, considering all the extremes and probabilities. This will help in exploring and devising a more inclusive range of possibilities and making an informed choice.
Overconfidence-related financial pitfalls can be successfully avoided by keeping an open mind, being open to feedback, and reevaluating past mistakes.
Sunk-cost Fallacy
In terms of personal finance, a sunk cost is simply a depreciating asset you hold onto because you made the initial investment and would have to book a loss if you let it go now. It is comparable to a bad movie you started watching but kept going because you were already halfway through. The bias exists because most investors find it challenging to accept making a poor choice, like investing in a failed business idea. They continue to invest more time, money and efforts in the hope of revival just because of the already heavy investment made. Simply because of the already significant investment made, they continue to invest more time, money, and effort in the hopes of a revival.
Sunk-cost fallacy can be avoided in the future by maintaining a detached attitude and a lack of personal attachment to investments while anticipating better opportunities ahead.
Conclusion
Awareness is the best defense against all psychological traps. You can incorporate discipline and other streamlined practices into your decision-making process to help you spot biases before they affect your judgment. Taking steps to recognize and avoid psychological pitfalls can also help you feel more confident about your decisions.
