Many people make poor investment decisions due to a host of emotional biases that undermine their chances of success on the market.
It is admittedly hard to escape the influence of emotions on investment decision making. In fact, that influence is probably the main reason why investors don't get the results they want.
However, being educated and aware of how emotions affect your decisions can be crucial in overcoming this risk, and make you a better investor in the process.
In order to improve your decision-making and investment results, it certainly helps to be aware of a variety of emotional biases that can work against you (without your knowledge):
1. Loss aversion bias
This ugly bias is one nearly every investor likely had to deal with at some point.
Loss aversion bias suggests we want to avoid losses more than we bother about gains. Ever held on to a poor investment because you didn't want to recognize your losses so that you didn't have to admit you were wrong? Or have you sold a winning stock quickly just to be sure you collect your gains, only to see the stock continue surging after your sale? Welcome to loss aversion bias.
Next time, examine your investment purely on its merits and avoid focusing on whether you are in the red or black.
2. Overconfidence bias
Overconfidence bias pretty much contributes to all stock market bubbles and occurs when investors believe they know more than others and that nothing can go wrong.
Novices are extremely likely to get carried away here and should again carefully examine their own assumptions when it comes to investments. Also, remain open to other opinions and welcome alternative viewpoints.
3. Regret aversion bias
This is a big one and practically points out the flaws of the human condition. Humans have a strong desire to be part of a herd. However, the herd doesn't necessarily come to conclusions with which we would agree.
The regret aversion bias assumes we submit to the consensus opinion about a stock merely because we are too afraid to abandon the consensus. If everybody loves Apple, for instance, why shouldn't we?
This bias can be potentially devastating because it suspends critical thinking. Investors should always question the views of others, especially when the majority of investors is concerned.
4. Self-control bias
Most people are guilty here: The self-control bias points out that investors focus to much on the short term and inadequately on the long term. An example would be that investors are spending a lot of money on consumption today instead saving for retirement.
Proper self-control and a balance between short- and long-term goals help in accommodating this emotional bias.
5. Status quo bias
Assume you own an investment portfolio that consists only of stocks and that the economy is heading straight into a recession. Common sense would dictate to shift at least part of your funds into bond investments. If you don't take any action at all, you are likely to exhibit the status quo bias.
In this particular situation an increasing allocation to bonds would have made a lot of sense as bonds do relatively well in a recession. The remedy: Always look at your entire portfolio and asset mix and don't be too timid too act when it is appropriate.
The Foolish takeaway
Emotional biases have a tremendous impact on investment success, but unfortunately many investors don't realize how easily influenced we all are.
Awareness about these emotional biases and a reflective approach to investing should certainly help people to make better investment decisions in the long run.