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3 Ways Your Brain Makes You a Bad Investor

By Kailey Hagen - May 13, 2021 at 9:18AM

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You might think you're being smart, but these mental shortcuts can actually be pretty dangerous.

The human brain can run circles around even the most advanced computers in terms of storage capability and generating new ideas. But like any superpower, our incredible brains have their kryptonite -- and it's making you a terrible investor. We know them as cognitive biases, and while there are hundreds, in this article we'll focus on three of the most significant when it comes to investing.

1. Confirmation bias

Confirmation bias is the tendency to seek out information that confirms your current beliefs while ignoring information that challenges those beliefs. This sometimes leads you to overlook pertinent information and feel overconfident in your decisions. And it can make a loss feel like it came from out of the blue, when all the warning signs were there. 

Shocked man with hands on face in front of falling stock chart

Image source: Getty Images.

For example, if you think Dogecoin is the next big thing, you might read a ton of articles about why Dogecoin is amazing, and that could reinforce your decision to invest a large chunk of your savings in it. But if you're not also reading articles about why Dogecoin might be a bad investment, you could be missing some key information that might have persuaded you to avoid it. That could cost you down the line if Dogecoin is usurped by another cryptocurrency in the future.

The best way to beat confirmation bias is to try to prove yourself wrong. Whenever you're going to invest in something new, do some research and look into why others are saying it might not be a great investment. You might decide that you don't agree with what the others are saying or that it's not relevant to your situation, in which case you may decide to proceed with your investment. But if you realize there's something important you overlooked, you might change your mind and save yourself from a costly mistake.

2. Information bias

Information bias is the tendency to treat useless information as if it is important. It's seeing patterns where there aren't any. That's easy to do in this day and age when there are more sources of investment advice than ever before.

If you search "why AMC stock is rising" online, you'll find plenty of articles walking you through the ins and outs of how the latest company news has affected its share prices. But too often investors, particularly inexperienced ones, feel the need to do something with that information when often there isn't anything to do about short-term price changes if you're buying and holding your investments for the long term. 

Overcoming information bias in investing is about recognizing what information is actually valuable and what's irrelevant. This takes some practice, and even for experienced investors, there isn't always a clear-cut distinction between the two. Every investor has their own strategy and others may take different information into account than you do, so you have to find out what works for you.

If you're investing for the long term, don't get too hung up on short-term ups and downs. In fact, it's better to not even look at your stocks' share prices if their day-to-day fluctuations make you tempted to buy or sell easily. Focus on what's going to affect a company's long-term performance.

For example, Zillow had a bad first quarter, but that doesn't necessarily mean it's a bad company. However, if it was steadily losing market share to a competitor, that could be a sign that it's time to get out.

3. Anchoring bias

Anchoring bias is the tendency to put too much weight on a single factor when making a decision. That could be basing your decision to invest exclusively on past performance or share price. Or it could be something else for you. But regardless, basing your decision on a single factor could be costly.

If investing were that simple, we'd all be millionaires. But it's a complex, educated guessing game based on how well we think certain companies are going to perform. And sometimes even the best investors get it wrong. You have to take a variety of factors -- including share price, price-to-earnings (P/E) ratio, management, competitive advantage, and economic trends -- into consideration to make the best decisions.

Part of learning to be a great investor is learning to recognize where biases like these come into play for you, so you can catch your mistakes before they cost you money. You might still make some of these mistakes some of the time, but if you make an effort to avoid the biases above and learn more about how to invest wisely, they'll become fewer and further between.

Kailey Hagen has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool owns shares of and recommends Zillow Group (A shares) and Zillow Group (C shares). The Motley Fool has a disclosure policy.

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Stocks Mentioned

Zillow Group, Inc. Stock Quote
Zillow Group, Inc.
$38.66 (-1.75%) $0.69
AMC Entertainment Holdings, Inc. Stock Quote
AMC Entertainment Holdings, Inc.
$25.46 (7.56%) $1.79
Dogecoin Stock Quote
$0.07 (-5.00%) $0.00

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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