6 investing fallacies and biases to avoid

Research has unveiled the influence of psychological biases when it comes to investors’ behaviour.

Whether they be fallacies, mistaken-beliefs, or myths, many investors are unknowingly influenced by these biases that affect their investment decisions.

Financially speaking, these fallacies or biases can be harmful if one is not careful.

1. Sunk cost fallacy

Sunk cost is a past cost (including time wasted or non-cash resources) paid, irrecoverable regardless of any subsequent action.

For example, you paid RM1,000 for a business convention. The night before the event, you come down with a bad cough.

Instead of seeking medical help, you attend the convention anyway because you don’t want to squander the RM1,000 paid.

Why avoid it?

It can make you act foolishly and incur a further loss.

The RM1,000 paid is non-refundable, gone, kaput regardless of whether you attend or not.

Not seeking medical help but instead attending the convention worsens your health condition (incurring a further loss).

You cannot concentrate during the convention and your constant coughing distracts others and makes you look bad.

How to avoid it?

It’s tough. Nobody likes losing. When we lose, the feeling is awful. But when we win, we act nonchalant as we had expected a return from our investment (money, time or resources).

Humans feel more suffering from loss than joy from winning. When we make poor decisions to “fix” or recover earlier losses, we lose further.

To conquer it:

• Practice awareness and logical thinking to make rational decisions.

• Determine your limit for loss and gains before selling or buying further. The concept of anticipation reduces the agony of losing.

• List out the pros and cons of your next action. This gives you a clear view of whether it’s worthwhile.

Everyone experiences failures during their lifetime. However, these are the best educators as it allows you to learn from it and plan a way out.

2. Hot hand fallacy

This is the false belief that a recent winning streak will continue without regard to other available data.

For example, a particular share has made profits every day for the past 15 days. Based on this profitability streak alone, an excited investor pumps in more money than he can afford, betting it will continue to rise regardless of other economic indicators.

The investor only considers one factor for buying the share i.e. its current upward trending.

Why avoid it?

For investing, being foolhardy is dangerous when the market is bullish.

Imagine emotions running high with prices rising for 15 days straight and market talk that this will continue for the next 10 days. Everybody is buying.

You’re thinking if you don’t buy, you will lose out (herd mentality). Thus, you invest more money than you can afford, all time-tested investment principles forgotten in the midst of the excitement.

The next day, Bang!… the market collapses (an extreme assumption) or the share price takes a sharp downturn.

Now you know why sellers of successful mutual funds always add the disclaimer “past performance is not indicative of future results”.

How to avoid it?

It‘s wise to be cautious. Investing with emotions is gambling. Instead of placing an investment decision on recent events, analyse the trends and patterns of share price movements. Unless you look for short-term gain, long-term investing is the way.

All debatable issues have its followers and detractors. Seek the views of the detractor, someone who disagrees with further buying of the share. Get their viewpoint. But insist on credible data.

Practice sound investing principles before parting with your money.

3. Gambler’s fallacy

Gambler’s fallacy is an incorrect presumption that says:

• If a particular event/effect/result recurs, the opposite is certain to occur soon.

• We often interpret the outcome of a future event by judging its corresponding past events even if the two are completely independent of each other.

The best example to illustrate this fallacy is the coin toss. Assuming the first four tosses were all heads, what do you think the fifth toss will be? Heads or tails? Tail rights? Since it was heads four times in a row.

That’s the answer most people give. Probability theory suggests the answer is 50/50 for either heads or tails. Past tosses do not influence a future toss result.

Why avoid it?

Emotional investing will not generate wealth. The stock market operates based on underlying company fundamentals.

In investing, gambler’s fallacy is widespread. Investors believe a share price’s continuous climb can’t last forever. As such, many start selling prematurely and lose out.

Today’s share price is independent of previous days’ prices. Investors should base their buy or sell decision on fundamental analysis (fundamental analysis refers to the examination of the economic health of an entity as opposed to only its price movements).

How to avoid it

Always remember that past successes or failures have no influence on the result of your next transaction. Investors should use fundamental analysis to predict what will happen.

Don’t gamble. Stop making investing decisions that depend completely on probability.

4. Loss aversion bias

An investor places more importance on avoiding losses than making profit.

For example, it is better not to lose RM1,000 than to gain RM1,000. An investor with loss aversion will suffer the loss twice as much if he makes a gain.

Why avoid it

Nobody likes to lose especially when it comes to investments. Many investors prefer not to lose money more than win money. In the risk-reward model, more weightage is placed on the risk factor resulting in inaction being the reasonable action.

Loss aversion does the following:

• Stops and prevents investors from disposing of loss-making investments.

• Makes investors overthink avoiding risk when assessing possible gains. Evading loss takes priority over making a profit.

• Makes investors hold on to losing investments while selling winning investments, resulting in them holding unbalanced portfolios.

Investors should take calculated risks to increase gains, not mitigate losses.

How to avoid it?

Losing is part of the investment game. No risk, no gain. Prepare an investment plan before you get into a trade. Give your investments some trading space to move and don’t set your stop losses too tight.

Misfortune is rooted in our mind. Whatever choice we make (although it is the most sensible), we try to become loss averse.

Giving up due to loss averse bias without justification can reduce your chances of winning. For example, if you don’t start up a business you always dreamed of just because you worry about losing money, you will lose in the real sense.

The greatest risk is living a risk-free life.

However, loss aversion bias helps a new investor avoid loss i.e. be less eager about making more money.

5. Over-analysis fallacy

Analysis paralysis. You over-analyse a situation resulting in inaction i.e. no outcome. This is when too much information results in brain freeze or paralysis.

Why avoid it?

Often, you come across a good investment deal. Your gut feel is to go for it. The main indicators are there. But your analytical background is cautioning you to analyse it further.

You cave-in (loss aversion bias) and seek further information. The more data you analyse, the more you are unsure. The deal passes by and that’s that. No action, no outcome. You just lost a chance to a 20% gain after three months.

How to avoid it

Many investors over-analyse with many statistics, indicators, checklists. There is news to look at, experts’ opinions and other indicators to digest. You want to be 100% sure you get it right before parting with your money. This leads to analysis paralysis.

Best solution? Stick to a consistent trading strategy that decides the following:

• If a share is cheap or expensive or of fair value.

• If a share is cheap/expensive, decide if you want to buy/sell the asset.

• Given that a share is fairly priced and if you hold a position in that share (bought or sold it earlier), decide if you want to exit that position or the price (or price range) that you want to make this trade at.

6. Confirmation bias

An individual favours recommendations or conclusions that establish his/her current belief.

It gets individuals to stick with information that confirms their own point of view and reject any suggestion that disagrees with it.

Why avoid it?

Confirmation bias shows that an investor is prone to seek knowledge that backs his or her opinion more than which differs with it.

For e.g. when you identify a trading signal, you’re expected to notice indicators that support your opinion. And not those against it.

We receive contradicting information differently. Because of one-sided information that is bias to our frame of reference, we make flawed decisions.

Investors will have a partial picture of a situation because of confirmation bias.

How to avoid it

When everything seems to support your market view or reinforces your idea, stop! Reflect further and look for reasons against your view. This can save you from slipping into the pit of over confidence.

This article first appeared in https://mypf.my