We’ve always preach not to allow your emotions to affect your investment decisions. Many times, we humans subconsciously commit illogical decisions. To avoid doing so, we need to be aware of the common fallacies that we may fall for. By being cognisant of the human condition, we are more likely to catch ourselves from committing any irrational behaviours. Today, we have identified 3 mistakes investors should avoid while doing their investment research.
(1) Confirmation Bias
Confirmation bias is a phenomenon where investors subconsciously seek out information only to confirm their existing opinions. They neglect information that contradicts their beliefs. The confirmation bias is a particularly insidious fallacy that investors can commit as it can skew research findings.
For example, Jon is an employee working in OCBC Bank and he strongly believes that OCBC Bank will be a good stock to invest. He subsequently tries to search information selectively that “confirms” OCBC Bank will be a good stock to invest, totally ignoring any bad information that may refute his beliefs. For example, he might Google “Why Invest In OCBC” when doing his research.
When confirmation bias is in play, investors believe that they have done adequate research and there is enough evidence to invest in a certain company. However, they are not aware of any other major or negative information that may indicate the company will not be a good investment. The research process will be extremely one sided, resulting in an irrational decision-making process.
To address the confirmation bias, investors should be aware of their research methods and processes. Investors should also actively seek information that refutes their beliefs. By acting against preconceived notions, they will be more likely to refuse to carry out any of their ideas until they are convinced to do so.
(2) Cognitive Dissonance
Cognitive Dissonance happens when investors are being presented with two contradictory information at the same time. This usually occurs when new information contradicts with preconceived notions or when two information contradicts with each other blatantly. When cognitive dissonance happens, investors experience mental discomfort. This is also another reason why they can succumb to confirmation bias as the confirmation of a certain notion can prevent mental discomfort.
When conducting investment related research, it is highly likely that most investors will often experience cognitive dissonance. When this happens, they will likely go with the more comfortable option (e.g. the more accessible information or some even drop out of their research entirely). Sometimes the options investors choose to alleviate their cognitive discomfort can have terrible repercussions such as missing a good opportunity to enter the market.
A good example will be the current property market in Singapore. There are contradictory news being published each day from multiple sources. On one hand, some people are saying that the market is currently bad and that it is a buyer’s market, with sellers rushing to sell their homes due to lack of demand. On the other hand, we also read of reports, usually from real estate companies, that the market is recovering and that buyers should get in now and sellers can afford to hold on. Which do we listen to? Most people just end up allowing the status quo to continue because they are unsure of what’s going to happen next.
Investors should continue with their research when they are faced with two conflicting information; try to make sense of why there are information contradicting with one another. They should not succumb to confirmation bias and neglect contradictory information. More often than not, contradictory information exists for a reason. When a well-rounded research is conducted, investors can evaluate the pros and cons fairly.
(3) Recency Effect
Recency effect is perhaps one of the more common biases that investors often commit subconsciously. Recency effect happens when investors place higher value and weight in events that occur recently. For example, when an investor buy a mutual fund based on its recent performance, he could be a victim of the recency effect.
When recency effect is in play, investors neglect to find out information about things that happened further in the past. Without taking into account of the information that happened further in the past, the decisions they make will be flawed. To continue the example from before, if investors fail to consider the previous performance of the same mutual fund (i.e. the fund has consistent annual performance of -12% for 6 years), they will be unaware that they are taking unnecessary risk.
While it is tempting to use recent events to rationalize and make easy financial related decisions, always remember to look at the entire picture before committing on a buy or a sell; micro and macro perspectives can tell different stories and provide contradictory information.
Fighting the Irrational Mind
Investors always believe that they are rational and justify every decision made. However, it is important to know that the majority of investors, even the experience ones, are always susceptible to fall victim to these cognitive biases that can affect decisions resulting in a less optimal portfolio performance.
By highlighting these 3 insidious cognitive biases, we hope that investors will be more aware of their behaviours when they are conducting any investment related research. Hopefully we can help to prevent investors from making any flawed decisions.