On January 17, Todd Harrison, the founder and CEO of Minyanville Media, an online news source serving the business and finance communities, published an article on his company's website that discussed common cognitive biases that prevent humans from behaving rationally. While these biases weren't meant to be specific to any person or group, Harrison suggested that investors could benefit from reviewing the list so that they could better manage their investment habits.
Topping the list of 12 entries was confirmation bias, which Harrison described as the "fatal flaw of trading." He suggests that by surrounding themselves with information that validates their viewpoint, investors may dismiss information that could draw a more accurate picture of the risks and opportunity.
Number 4 on his list, a classic one impacting investors, is post purchase rationalization. No one like to be proven wrong or to have to admit to having made a bad decision. As a result we often rationalize our investments that have gone awry and stay in them far too long. As Harrison points out, "We should be wise to remember that good traders know how to make money but great traders know how to take a loss". The SmartStop risk alerting service is particularly helpful in addressing Post Purchase Rationalization, serving as a catalyst to review positions when risk rises and question your initial hypothesis.
Additional biases that investors should watch out according to Harrison are:
• In-Group Bias – or surrounding themselves, and following the advise of, like-minded individuals
• Gambler's Fallacy – thinking that the previous role of the dice will impact the odds of a future role of the dice.
• Neglecting Probability – a bias that prohibits investors from properly considering risk
• Observation Selection Bias – being more aware news associated with our purchase and assuming news events have increased
• Status-Quo Bias – Staying within our comfort zone
• Negativity Bias – Focusing on bad news and missing opportunities
• Bandwagon Effect – Everybody thought Apple would straight up until it didn't
• Projection Bias – Projecting your believes or opinions on others
• The Current Moment Bias – mortgaging our future for today's gratification
• The Anchoring Effect – Comparing an investment to a proxy that may not be appropriate.
A good approach to guard against the potential harmful impact of these biases it to employ an unbiased system or process in your investment decisions.
At SmartStops, our portfolio monitoring service deploys logic driven algorithms to monitor the risk state of individual equities and sends out risk alerts when the risk state of any of your equities change, eliminating the guesswork that can be affected by these biases.
Categories: Risk Management, Trading & Portfolio Strategies