Financial markets are becoming increasingly efficient, particularly so in recent years thanks to the advent of information technology and algorithmic trading systems.
At the same time, there’s also plenty of evidence to suggest that individuals still have plenty of opportunities to maximize their profit-making potential by focusing on eliminating certain behavioural biases that stand in the way of arriving at the optical investment decision.
Here are five behavioural biases you should seek to avoid in your pursuit of investment riches:
Endowment bias takes place when an investor places greater value on the securities that he or she owns.
For example, say you held shares in Toronto-Dominion Bank (TSX:TD)(NYSE:TD) trading at $77 on the TSX at the time of writing.
Maybe you wouldn’t be willing to buy more shares at that price, but you’re happy to hold on to them as you don’t think they are a particularly bad investment.
Essentially, you’d be assigning an additional value to TD Bank stock just because you already to own it.
Endowment bias tends to inflate the perceived value of an investor’s current holdings, leading to individuals holding on to securities for too long and potentially missing out on newer, better ideas.
Loss aversion builds on the notion that investor dislike losses more than they like gains.
In other words, an investor would feel more discomfort losing $100 than they would feel pleasure with a comparable $100 gain.
This bias tends to lead investors to hold off or delay on selling losing positions in order to avoid the discomfort associated with realizing a loss in their portfolio. It can often lead to making an undesirable investment outcome that much worse.
Everyone reading this probably knows of at least one person out there who regularly falls victim to this behavioural bias.
Overconfidence results when investors hold an unjustly high conviction in their own ideas, prompting them to take inappropriate risks in their portfolios and trading excessively – a behaviour that has been frequently linked to poor investment returns.
Mental accounting arises when individuals view their wealth in separate “buckets” depending on where the money is being held.
For example, savings held in a checking account are viewed through a different lens that those held in a savings account or GIC.
An improper understanding of an investor’s overall portfolio (which could also include personal property and a primary residence) can in some cases lead to suboptimal investment decisions. It’s a subject that is better discussed in more detail with a licensed financial representative.
Individuals find themselves guilty of confirmation biases when they seek out information that confirms their existing beliefs.
This can involve seeking out opinions that are consistent with their own views or someone putting a favourable “spin” on an otherwise neutral piece of information.
Confirmation bias is also consistent with several other behaviours, including holding losers for too long and being overconfident about a particular investment forecast.
Generating above-average returns in the markets is certainly no easy task, and requires a disciplined approach with a careful view to the long-term.
Avoid these common pitfalls and you’ll undoubtedly go a long way toward achieving your financial goals.
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Fool contributor Jason Phillips has no position in any of the stocks mentioned.