Most common mistakes new investors make

By Roshan Pourghasemi

Economics is mostly based on the fact that everyone is a rational consumer, meaning everyone acts logically in their decision making. In reality, however, people tend to be emotional and very rarely make perfectly logical decisions. In order to become a better investor and reach financial freedom, it is important that you understand what biases exist, which biases you have, and how to best counteract them.

Key Takeaways

Types of Biases

It would take a college degree to fully understand every bias present when making financial decisions, but the following are some of the most common ones and a brief overview of what they mean:

• Overconfidence bias - the tendency for people to overestimate their knowledge of financial markets and specific investments. This also leads individuals to disregard data and expert advice. This commonly manifests itself in trying to time the market or believing that a risky investment is a given to pay off.

• Mental Accounting - the tendency for people to value money differently based on how they got it/ what they plan on spending it on. A good example of this is buying a luxury with your tax refund because you think that it is extra money that you didn’t have in the first place, while, in reality, this money should be treated as if it was your paycheck. By treating the money as different, you could spend it on something that you don’t really need vs. using it to pay off some sort of debt.

• Loss Aversion - the tendency that loss tends to feel worse than gain, even when they have the same respective amounts. For example, let’s say that you’re playing poker. The psychological effect of losing $10 in a hand tends to be twice as powerful as the effect of winning $10. This can cause individuals to make illogical decisions to avoid the potential losses involved.

• Anchoring - a cognitive bias that refers to the purchase price of a security carrying a disproportionately high weight in an investor’s decision making process. One common consequence of anchoring is when an investor holds onto an investment because of its purchase price when the investor bought it, even though its fundamentals and other factors show that it has clearly lost value. The investor assumes greater risk based on the assumption that the investment will someday return to its purchase price, even if other factors show that this is unlikely.

• Herd Behavior - the tendency for people to join in groups and follow the actions of others, assuming that others have already done the necessary research. This can cause investors to fail to do their own analysis and just follow what other investors are doing. This takes away an individual’s decision making ability and leaves them susceptible to getting blindsided by the market.

• Framing Bias - the tendency for people to interpret information differently based on the way it was presented, which can lead individuals to make ill-advised decisions. Investors commonly come across framing when looking at figures or reading analysis of securities.

• Availability Bias - the tendency for people to weigh information that comes to mind the quickest the most to make decisions about the future. This can lead to illogical decisions because memories that come quickly don’t usually carry enough information to accurately make a decision about the future.

How to Avoid These Biases

Since these biases greatly impact your decision making, it is important to overcome them if you want to see financial success.

Behavioral biases can generally be categorized into a cognitive error or an emotional bias. Cognitive errors come from basic lack or misunderstanding of information and stem from faulty reasoning. Emotional bias comes from intuition or impulse and stems from reasoning that is influenced by feelings.

Cognitive errors are easier to fix because they can be corrected by spending more time researching and reevaluating your faulty reasoning. Emotional biases are trickier since they stem from your emotions and those can be much more difficult to change. The first step in eliminating both these biases from your decision making process is to realize which biases you are susceptible to. As an exercise, try and recount your most recent decisions and see if you can categorize any of your reasoning into one of the categories mentioned above. Once you do that, you’ll be ready to take the steps necessary to combat those biases.

Below are some fixes that correspond to each bias:

• Overconfidence Bias - the most obvious step is to listen to the advice of people you trust and have more experience in the field. Also, it can help to see how well you understand a security by pitching it to someone else. If they’re not sold or you don’t have much to say about it, you probably need to do more research before committing to it.

• Mental Accounting - budgeting is one of the best ways to combat mental accounting. By budgeting, you can see what your most pressing needs are. Also, it is important to remember that money is fungible, meaning that all dollars are equal, and make decisions as such.

• Loss Aversion - you can avoid loss aversion by not becoming too emotionally invested in your investments. By doing this, you can try to weigh gains and losses equally and make better decisions.

• Anchoring - you can avoid anchoring by taking time in your decisions and arguing against the investment you are anchored to. If you can make a strong argument against holding that investment, it may be time to let go.

• Herd Behavior - the best way to avoid her behavior is to do your own research for every financial decision you make. By doing this, you understand the pros and cons of a security, and you will be less susceptible to unexpected surprises.

• Framing Bias - the best ways to avoid framing bias is to dig deep into how information is being presented to you and then trying to frame it in a different way. It also helps to look at information through different lenses and perspectives. If you feel very differently based on how you framed the information, it can signify that you may need to research more before making a decision.

• Availability Bias - to avoid availability bias, you should take a step back and look at all the information available to you, instead of just thinking about what is readily available. It may also help to focus on trends and patterns when making decisions.

Of course, it is nearly impossible to completely eliminate bias from your decisions. Humans are emotional beings, after all. Still, by acknowledging your biases and taking steps to combat them, you’ll be better equipped to make decisions and that will pay dividends.