5 Common Behavioural Biases That Every Investor Must Avoid

You may consider building and managing your mutual fund portfolio with the right asset allocation. You will have to decide how to invest, time the entry and exit of your investments, and monitor and rebalance your equity portfolio. 

After analysing available information, you can decide to reflect the expected performance and risk associated with your investment.

You will find many investors making financial decisions based on emotions. You must base your investment decisions on solid market research rather than an emotional response. Otherwise, you could lose money if you allow fear, greed and other emotions to influence your financial decisions. 

Let’s take a look at five behavioural biases investors must avoid:

1. Optimism Bias

You can consider optimism bias to be a mistaken belief that your chances of experiencing an adverse event are lower than peers. Moreover, the chances of experiencing a festive event are higher than those of your peers. 

You also cultivate the belief that you can outperform the market based on some of your successes. However, these successes are more an outcome of chance rather than knowledge or skill. 

It would help if you did not allow optimism bias to influence financial decisions or base decisions based on what you feel is correct rather than objective information. It encourages risky decision making, which could result in you suffering a loss in the stock market.

2. Familiarity Bias

You have a familiarity bias where you prefer to invest in asset classes that you are familiar with or have more important information, and so on. For example, you may invest only in real estate firms’ stocks or pick shares of a particular company. 

It could result in a concentrated portfolio which may not match your risk profile and investment objectives. You may also find your portfolio underperforming as compared to the benchmark over some time. 

3. Anchoring Bias

You may be a victim of anchoring bias if you continue to hold information that could no longer be relevant, and you make financial decisions based on this information. You label any new information you receive as irrelevant to the decision making process. 

For example, you continue to hold losing stocks with the expectation of the price reaching levels that are no longer viable based on current information. You wait for the right price to sell your stocks even when new data shows the expected price is unattainable. It could impact the performance of your portfolio. 

4. Loss Aversion

You could fall prey to loss aversion if the fear of losses with investments leads to inaction. You will feel the pain of a loss twice as substantial as a gain of similar magnitude. You prefer inaction despite information and analysis showing that a particular action could be appropriate, as you fear suffering losses with your investments. 

You may end up holding losing stocks as you prefer inaction over making the right investment decisions. You may console yourself that you have not suffered a loss as you continue to keep the investment. 

It helps if you use stop-loss orders to minimise potential losses while investing in stocks to eliminate loss aversion bias. Otherwise, you may end up selling winning stocks before you make a decent profit and holding losing stocks which impact portfolio performance.

5. Herd Mentality

You may consider herd mentality as the tendency to follow what other investors do. You are influenced by emotions rather than independent analysis. For example, you invest in a stock because everyone is buying it or purchasing the so-called hot shares. 

You will find small investors watching other market participants for confirmation before making investment decisions. It could lead to you entering the stock market when it is poised for a correction or overheated. You could fall victim to stock market bubbles if you follow the herd when making financial decisions.