15 Biases That Can Screw Up Your Investing

Many times a day, in many areas of our lives, our brains get in our way, leading us to think or assume things we shouldn't, due to various biases. These biases can be especially costly when it comes to our money management and investing. Here's a brief look at 15 common biases to be aware of -- and try to avoid succumbing to.

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Herd mentality bias, when we're inclined to follow the crowd, has been a factor in many of our lives since our early school years. If the cool kids are doing or wearing certain things, we will often want to do the same. In investing, if people are jumping into the market in droves, or fleeing en masse, it can be hard not to follow the crowd. But that's often the best thing to do. Try to tune out what others are doing and think for yourself.

Confirmation bias will have us looking for confirmation of what we think. So if you're intrigued by a certain stock and think it might be a powerful performer in your portfolio, you'll seek out others' articles and thoughts that are also bullish on the stock, paying a lot of attention to them, and you may discount the opinions of those arguing against the stock's merits. It's best to give serious consideration to both bullish and bearish views of various investments.

Here in the 21st century, we're blessed with gobs of information on just about any topic we can think of, and much of it is at our fingertips, on our phones or computers. When we succumb to information bias, we will count lots of pieces of information as important -- even when some of it is not. For example, with investing, you might pay attention to a stock's price changes throughout the day, when that's generally not meaningful. (Instead, focus on the company's growth, financial health, risks, and opportunities.) Similarly, if a Wall Street analyst slaps a buy rating on a stock, that's not as meaningful as you would think. The vast majority of analyst ratings are positive or neutral.

ALSO READ: 3 Reasons Why It's Smart to Ignore Wall Street's Analyst Ratings

Overconfidence has long been known to be unhelpful in investing, as it has people thinking they're more skilled and insightful than they actually are. Dr. Terrance Odean has authored or coauthored several papers on this topic, and in an interview he said that "when investors are overconfident, when they think they know more than they do, when they think they're better investors than they are -- those investors will trade more, and that trading will hurt their return." (His research also found men to be more overconfident than women.)

The familiarity bias will, among other things, have you favoring familiar companies or familiar industries when you invest. It's good to be familiar with and have a solid understanding of companies and industries, but don't just stick with one or two. For best results, spread your dollars across at least a few different industries and, ideally, a bunch of companies. (If you want to invest in individual companies instead of, say, excellent index funds, we recommend investing in at least 25 companies, aiming to hang on for at least five years.) Familiarity bias may also have you only investing in American companies, when you might do well to include some exposure to international stocks, too.

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We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

An anchoring bias will have you giving too much importance to a piece of information when making a decision. For example, in investing, we will often focus too much on a stock's share price at a certain point. Imagine two people interested in buying shares of Scruffy's Chicken Shack (ticker: BUKBUK). One, seeing that it's priced at $100, decides it's too expensive. But the other remembers that it was trading at $150 a while ago and decides it's a bargain. The $150 price shouldn't matter much in the decision. What matters is how attractive a price $100 is, given an investor's estimate of how Scruffy's will grow over time.

ALSO READ: An Introduction to Behavioral Finance

We succumb to a loss aversion bias when we are more eager to avoid a loss than receive a gain. For example, imagine that you're invested in Company A, and you're currently down 50% on the stock, with much less confidence in it than you used to have. You see Company B as a much more promising and attractive investment, but you don't want to sell your shares of A, realizing a net loss. The smart thing to do here would be to forget about that 50% loss (where you're anchoring on your purchase price) and sell, and then move whatever funds remain into Company B. You will probably have a greater chance of making up your loss from stock A with an investment in stock B.

Self-attribution bias will have us crediting ourselves with investment savviness for investments that turn out well -- when some of our good investing outcomes may just be due to good luck (such as fortuitous timing). Meanwhile, we may take little or no credit for investing blunders, chalking those up to bad luck.

The representativeness heuristic is a mouthful to say. It refers to a tendency to assume that two things that are similar in one or more ways are similar in other ways, too. So, for example, in investing, we might assume that if an investment we made in a cybersecurity stock delivered a terrific performance, an investment in another cybersecurity stock is likely to do the same. Another example would be if you get overly excited about a company referred to as "the next Apple" when it only shares a few traits with Apple -- and isn't that likely to perform quite as well as Apple has. People suffering from this bias will often ignore probability.

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With the disposition effect, investors tend to hang on to assets that have lost value (due to loss aversion), and they are more willing to sell assets that have gained in value. So, for example, if you're intent on investing in a new stock holding and you'll have to sell some shares of a stock you already own in order to generate the funds for the purchase, you'll be too stubborn to sell your loser, even though its prospects may be poor, and you'll sell shares of your winner, even though it may be poised to keep growing and delivering more gains for you over many more years.

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We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

The world in general and the world of finance are both rather complicated in many ways. It can be helpful when we simplify some concepts for ourselves, but it can be taken too far, too. The oversimplification tendency has us oversimplifying certain things and basing decisions on that. For example, there may be several biotechnology stocks working on drugs to treat a certain disease. If we invest in one of the stocks because we think its drug will hit the market first, we may be making a mistake, overlooking the efficacy and cost of the various drugs, among other things. We're best off digging into and learning a lot about industries of interest. We should learn where our circle of competence is, respect its boundaries, and perhaps widen it through learning.

The endowment effect is a bias that has us giving more value to certain things we own than they really have. For example, if your grandma made a killing with her New York Times stock decades ago and left you some shares of it, you might be hanging on to them because of your love for grandma -- or for your love of newspapers -- more than your conviction in the newspaper company's future potential.

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Status quo bias has us favoring what we have over what we might have, resisting the idea of change. This can apply to new investments, new research findings, and more. As an example, if you've done well with growth stocks and you read that adding dividend-paying stocks to your mix is a good idea, you might reject the idea, even though it might do your portfolio well, adding some diversification. Meanwhile, someone who knows and understands and owns bonds might not like the idea of investing in stocks, even though they have outperformed bonds over most long periods.

Survivorship bias is when we focus on winning investments, investors, or ideas -- forgetting about or discounting those that flamed out. One example might be if you see some data offering average hedge fund returns over, say, a 20-year period. You might not realize that the data excludes many funds that went out of business during the period and ended up not being counted in the results.

ALSO READ: Beware of Survivorship Bias

Finally, there's the narrative fallacy, which is a deeply human one -- having us especially drawn to stocks or investments that have good stories, and possibly overlooking alternative investments with more boring backgrounds. Falling victim to this bias can also have us favoring exciting growth stocks at the expense of value stocks. Value stocks might have stories or descriptions that are less exciting than those of growth stocks, but they might have exciting prospects, due to being undervalued.

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Presented by Motley Fool Stock Advisor
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by The Motley Fool. I’d be sitting on a gold mine!" It's true, but we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Click here to learn how you can grab a copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

These are only some of the many biases out there that we might be unwittingly acting on. It's worth spending some time reading up on psychology and on behavioral finance in order to learn about thinking traps that are best avoided.

Selena Maranjian has positions in Apple. The Motley Fool has positions in and recommends Apple and The New York Times. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple, short July 2022 $48 calls on The New York Times, and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.