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Sometimes when we disagree on something we believe so firmly, we deny any other perspective.
A cognitive bias is an error in thinking that occurs when we are processing and interpreting information. Oftentimes, they are a result of the brain’s attempt to make information processing easier. Our brain creates rules of thumb to help us make sense of the world and reach decisions with relative speed. Unfortunately, the process of speeding up the decision process can sometimes lead to errors.
When it comes to investing, cognitive biases can make our investing behavior illogical. This can lead us to make undesirable financial or investment choices because we draw incorrect conclusions based on some of the thinking errors our brain is making to arrive at those decisions.
To be a successful investor over the long term, we need to understand, and hopefully overcome, some of these common cognitive biases. Doing so can lead to better decision making, which may help lower risk and improve investment returns over time.
Here, we highlight four prominent behavioral biases common among investors. In particular, we look atloss aversion, anchoring bias, herd instinct, overconfidence bias, and confirmation bias.
Confirmation Bias
Confirmation bias is the tendency to seek out information that confirms our existing beliefs and ignore information that contradicts them. In trading, this can lead to a trader only seeking out information that supports their bullish or bearish outlook on a particular asset, and ignoring data that suggests otherwise.
To overcome confirmation bias, traders need to actively seek out information that challenges their beliefs and consider all possible outcomes. One strategy is to keep a trading journal where you can document your thoughts and feelings about trades, and review them later to assess whether you were influenced by confirmation bias.
Anchoring Bias
Anchoring bias is the tendency to rely too heavily on the first piece of information encountered when making a decision. In trading, this can lead to traders fixating on a particular price point or target, and ignoring new information that suggests a different outcome.
To overcome anchoring bias, traders should remain open to new information and adjust their expectations accordingly. One strategy is to set multiple price targets based on different scenarios, and adjust them as new information becomes available.
Loss Aversion Bias
Loss aversion bias is the tendency to feel the pain of losses more strongly than the pleasure of gains. In trading, this can lead to traders holding onto losing positions for too long, hoping that they will eventually turn around, and selling winning positions too soon to secure a profit.
To overcome loss aversion bias, traders should set strict stop-loss orders to limit losses and avoid emotional decision-making. One strategy is to set a maximum loss limit for each trade and stick to it, regardless of whether the trade is winning or losing.
Overconfidence Bias
Overconfidence bias is the tendency to overestimate one's own abilities and knowledge, leading to excessive risk-taking and trading errors. In trading, this can lead to traders making large, risky bets based on their own intuition and disregarding the potential downside.
To overcome overconfidence bias, traders should maintain a healthy skepticism and seek out alternative viewpoints and information. One strategy is to engage in regular self-assessment and analysis of past trades to identify areas for improvement.
Conclusion
Traders tend to make decisions based on their intuition, which leads to cognitive biases such as confirmation bias, self-serving bias and hindsight bias. These biases cause traders to display psychological attribute of overconfidence such as miscalibration, better than average effect and illusion of control over a decision, and thus, display overconfidence bias in their decision making in the securities market.
By doing so, traders can improve their decision-making and increase their chances of success in the unpredictable world of trading.
