Psychological & Behavioural Investing Pitfalls to Avoid

There are many well‐documented psychological biases which adversely affect our financial decision‐ making and which we are all occasionally subject to. If you know what they are, you are probably less likely to be adversely affected by them. Whatever you do, do not believe for a moment that you are invulnerable to these behavioural habits, you are; you’re human! Here is a list of several of them:

Mental Accounting

Giving less value to some money. One example is the “House Money” effect: if you are fortunate enough to win at a Casino you may be more ready to gamble the winnings.

Myopic Loss Aversion.

To focus on avoiding short‐term losses, even at the expense of long‐term gains.

Sunk Cost Fallacy

The tendency to “throw good money after bad.” or value something based on what you have already spent rather than what it will mean in the future.

Status Quo Bias

The tendency to want to keep things the way they are.

Endowment Effect

Seeing something you own to be worth more than it would be if you didn’t own it.

Regret Aversion

To avoid or delay an action due to a fear that you might not get the optimum result

Money Illusion

A belief that ignores inflation and views money with a fixed value in terms of its purchasing power.

The Law of Small Numbers

Exaggerating the degree to which a small sample resembles the population from which it is drawn.

Recency Bias

Giving more importance to recent events and forget events in the less recent past.

Anchoring

Clinging to a fact or figure that should have no bearing on the decision. Often, we use an initial value as a “starting point” in decision making. Even if the initial value was a totally random uneducated guess, we tend to be biased towards it.

Confirmation Bias

The tendency to look for, favour, and be overly persuaded by information that confirms our initial views. Conversely, we tend to ignore and dismiss important information which tends to disprove them.

Overconfidence

Overestimating our own abilities. People tend to think that they are much better forecasters and estimators than they are. 

Information Cascades

The tendency to ignore objective information and instead focus on emulating the actions of others This is also known as herding. .

Credulity

While we might like to believe that we are all perfectly rational, reality is far different. Unfortunately, we tend to be susceptible to the manipulative messages from the financial industry and the popular press. Specifically, companies tend to conspicuously advertise positive information, while suppressing negative information. The popular press encourages investing issues where it helps them sell magazines rather than from evidence.

The Dunning Kruger Effect   

This is a cognitive bias in which unskilled people make poor decisions and reach erroneous conclusions, but their incompetence denies them the meta cognitive ability to recognise their mistakes. The highly skilled are more likely to underrate their own abilities. “Ignorance more frequently begets confidence than does knowledge”

October 2019 by David Cockling