Investing is a tough slog in even the best of times. Not only does it require a significant amount of time and effort on your part, but since there are no intramural leagues for investors, you're always playing on the same field as the Michael Jordans, Brett Favres, and Derek Jeters of the investing world.
Of course there are resources available to help investors learn more and share knowledge, and there are actually advantages that individual investors have over their salaried counterparts.
But one thing that none of us -- novice and expert investors alike -- can get around is the fact that we're human. And though we may be highly evolved, there are still some ways that our brain can work against us and make us feel more like monkey than man.
Let's take a look at a few of the psychological biases that are waiting in the shadows ready to sabotage our investing success.
Outcome bias
Outcome bias describes the tendency for people to judge a decision-making process based on the outcome. This is a slippery slope for investors because no matter how much up-front research and analysis you do, there's still a possibility that an investment could go south. Judging that sound process based on the lousy outcome would be a mistake, since that kind of rigor is likely to produce more winners than losers over the long term.
Let's take Apple (NASDAQ:AAPL) for example. There's no doubt that the stock has been a rousing success -- even with the bear market, it's still up some 800% over the past five years.
But does that fantastic outcome mean that an Apple investor who bought the stock because he liked the company's logo made a smart investment decision? For a victim of outcome bias the answer would be "yes," and that could be used as reason to employ that same terrible investing process again in the future.
The bottom line is that there's a lot more to the wisdom behind an investment than just the eventual outcome. Investors who are able to step back from the outcome and honestly evaluate whether the decision-making process that led to the outcome was a good one are setting themselves up for future success.
Ambiguity effect
This next bias describes the fact that people often avoid situations where the absence of information muddies up the decision-making waters. In the investing world, where only very rarely do you have every single data point you'd like, avoiding uncertainty altogether could leave you with precious few investment choices -- and rarely the best ones.
Take the recent situation in the banking industry, for instance. Back in March, the stocks of financial institutions such as Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS), and Wells Fargo (NYSE:WFC) were languishing because of the myriad unknowns in the world of finance.
Investors who were willing to dive in and use what information was available, though, may have come to the conclusion that these names were worth the risk. The final chapter hasn't been written yet, but so far those investments have paid off with the stocks returning anywhere from 50% to more than 200% over the past few months.
I'll be the first to echo Warren Buffett's advice that there are no called strikes in investing. However, completely avoiding all situations where there isn't complete information could mean that you're missing out on some great investment opportunities.
Availability heuristic
Our third tripping point arises from predicting the probability of an event based on how easily certain instances can be called to mind. As investors, it's important that we make our predictions based on all information available, not just that which is most recent or most memorable. Predicting the future is brutally difficult, but getting wrapped up in the availability heuristic can make that task a heck of a lot more challenging.
Here we could simply consider the experience of the entire stock market. Over the long term, investing in stocks has proven to be a pretty profitable endeavor. However, investors considering the advisability of investing in individual stocks right now may be spooked by the past few years in which everything from General Electric (NYSE:GE) to Merck (NYSE:MRK) has taken a shellacking.
This, of course, would be a mistake, since such a decision primarily relies on recent evidence and not the breadth of history available to consider. A more thorough analysis might reveal that now could be a pretty darn good time to be a buyer.
Looking on the bright side
For the reasons outlined above, we could all benefit from removing these decision-making biases from our investing. But there's more to it than that. Once we've flushed these demons from our own portfolio we can use the fact that other investors are falling victim to them to help us find some great investing opportunities.
An example of this can be found in our Motley Fool Hidden Gems service, where advisors Seth Jayson and Andy Cross recommend stocks exclusively from the lesser-followed realm of small caps.
While the picks do include some better-known names like Chipotle Mexican Grill (NYSE:CMG), they also include lots of under-the-radar businesses like Innophos -- a company that creates specialty phosphates that provide certain attributes like taste and texture to everything from sports drinks to toothpaste. You can check out all of the Hidden Gems recommendations by taking a 30-day free trial.
Of course, whether or not you take a peek at the Hidden Gems portfolio, you can do what I'm doing and start monitoring your investing process for dangerous decision-making biases and keep another eye out for where those same biases are causing other investors to serve up fantastic investment opportunities.
Apple is a Motley Fool Stock Advisor pick. Chipotle and Innophos are Motley Fool Hidden Gems recommendations. The Fool owns shares of Chipotle and Innophos.
Fool contributor Matt Koppenheffer owns shares of Bank of America. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool's disclosure policy never falls into psychological traps, but then again, it isn't human. Nor is it a Transformer. But boy does it wish it were a Transformer.
