— Anchoring Bias

When individuals rely too heavily on past reference points when making decisions for the future, "anchoring" occurs, leading to "anchoring bias." This bias can cause many problems for investors and is an important concept in behavioral finance.

For instance, if you first invested in stocks and reaped favorable gains, your perception of future stock returns may remain positive, even when there are clear signs that the stock might plummet. It is crucial to remember that financial markets are highly unpredictable, so when making significant investment decisions amid uncertainty, you need to maintain flexibility and seek professional advice.

— Herding

Also known as mob mentality, this is a strategy passed down from our ancestors that believes in the power of the crowd. Unfortunately, this is not always the best strategy in financial markets, as following the crowd is not always the right move.

Ironically, this laissez-faire attitude among investors is a major cause of "bubbles" in financial markets. Investors often "follow" to ensure reputation and make decisions based on past trends or past successes of other investors in the same stocks. However, when a company is hit by unfavorable news, people quickly sell off stocks, and when stocks perform well, people frenetically buy them.

Advertisement

As an investor, you should conduct your own analysis and research for each investment decision and avoid the temptation to follow the majority.

- Loss Aversion

Loss aversion is the reason why people go to great lengths to avoid losses, as the pain of a loss is twice the joy obtained from an investment gain. Simply put, losing one dollar is twice as bad as gaining one dollar.

As emotional beings, we often make decisions to avoid losses, which may involve investors pulling funds out of the market when it dips, leading to a greater accumulation of cash, or investors avoiding holding assets after a market adjustment to avoid losses in cash form.However, the sense of security in exiting the market during instability only leads to a large amount of cash circulating in the economy, thereby causing inflation. During the financial crisis of 2007, there was an increase of $943 billion in cash within the U.S. economy.

Investors can avoid the trap of loss aversion by talking to financial advisors to understand how to minimize losses and optimize their portfolios for higher returns.

— The Trap of Overconfidence

When investing in the stock market, confidence is an asset, but overconfidence or narcissism can lead to the downfall of investors. Many investors, especially those who are well-educated and have a good understanding of finance and the workings of the stock market, often believe they know more than independent financial advisors.

It is important to remember that financial markets are complex systems composed of many different elements and cannot be outsmarted by a single individual. In the past, many investors have lost substantial amounts of money simply because they fell into the psychology of overconfidence and refused to accept advice from anyone. Overconfidence is the most dangerous form of carelessness.

— The Confirmation Trap

The confirmation trap refers to investors seeking information that confirms their views and ignoring any theories that refute those views.

When investing in a stock they believe will yield favorable returns, investors will filter out any information that goes against their beliefs. They will continue to seek advice from those who give them bad advice and make the same mistakes. Since investors tend to look at only one side of the coin, this leads to biased decision-making.

For example, investors will continue to hold onto stocks that are decreasing in value simply because others are doing the same. Investors can help each other confirm the reasons for keeping the investment, but this is not a viable strategy in the long run, as both investors may ultimately suffer losses. Investors should seek new perspectives on stocks and conduct a fair analysis of their investments.