5 Psychological Biases that kills your Return as an Investor

The human brain gets in the way of you achieving superior returns, learn 5 strategies to counter common investing biases, and increase your returns long-term.

1. Hindsight bias

Hindsight bias is our tendency to look back at unpredictable events and think they were predictable.

Investors may believe they knew the market would fall 25%+ in march 2020, but the information we have now was not available at that time. It deludes investors to believe that future events will be predictable, which they won’t be. In the next crisis, you will not be able to tell what the market will do.

“In the business world, the rearview mirror is always clearer than the windshield”

- Warren Buffett

2. Herd mentality

This bias describes how people are influenced by what the majority consensus is.

We are hard-coded into following the herd. 2000 years ago, if you didn't stick with the herd, it meant death. Today, it leads you to follow consensus on stocks and markets. Think about everyone buying Bitcoin in 2021 at all-time highs. Remember, if you follow the herd you will get average (or worse) returns.

Having a contrarian view, and being right is very hard, but it is what yields the highest returns.

3. Chasing Trends

We tend to follow past trends and believe that they will come back to their glory. Examples: Environmental businesses, innovative tech, crypto, FAANG. Our worldview is colored by our previous experiences. Entering the bull market from 2009-2021, investors are much more likely to favor growth, technology, and “Big Tech” as this is where the biggest gains have been in recent memory.

Trends that are backed up by revenue, earnings, and cash flow is OK. But trends that are built on promises and a PowerPoint presentation are very dangerous. The crypto bubble is a great example, also the green energy surge after march 2020 was not based on fundamentals, but rather the belief that future returns will be high. Also called the “greater fool theory”, where you rely on selling your investment to an even greater fool, willing to pay even more than you.

4. Loss Aversion

Loss aversion is the human tendency to feel a loss more negatively than the positive feelings of winning the same amount. Losing 50% of your portfolio feels almost twice as bad as the joys of gaining 50%. Human nature tells us to sell when a stock or the market is down 30-40-50%, we just can’t deal with the loss (pain).

Loss aversion is the cause of many bad investing decisions. Selling at just the wrong moment, when your assets are at multi-year lows is how you lose money in investing.

Having a strategy to know what you own, and why you own it is essential.

5. Confirmation bias

Confirmation bias is our tendency to cherry-pick information that confirms our existing beliefs or ideas. ****If we are not aware of this bias, we look for information that confirms our current beliefs, instead of looking for the objective truth. We tend to ignore information that contradicts what we believe.

When analyzing stocks, one should try to be completely unattached to the outcome. If you go into the research phase already wanting to invest in a specific company, chances are you will fall victim to confirmation bias and weigh the facts that support your thesis more than those facts that contradict it.

Be aware of this bias when analyzing a stock - Confirmation bias can make any business seem like a great investment

How to deal with these biases

There are a few good strategies you can apply to your investing process to counter these biases. The first thing is being aware of them. As long as you know about them, you can catch yourself doing stupid things in the stock market. This becomes very obvious as you become a more experienced investor.

Strategy #1: Write down your investing strategy. Be specific and stick to your strategy.

Strategy #2: Create a checklist before buying. All great investors have a checklist. Why? Because they are human, they make shortcuts and are susceptible to biases just the like rest of us.

Strategy #3: Invest with a 5+ year time horizon. Long-term thinking is counter to many of these biases that are short-term in nature.

Strategy #4: Diversify - “Don’t put all your eggs in one basket”. However, if you have 20+ companies, just buy an ETF. 8-15 companies are my preference.

Strategy #5: Automate investments as much as possible. Automation takes the emotional mind out of the decision and helps you stay consistent.