Investing 101 - Cognitive Bias
If you can remember, we have talked about some tips for amateur investors in the past few weeks. So from now on, we are about to get to know different types of cognitive biases, and ways that they impact our investment decisions.
There has always been a common misperception amongst beginner investors - they often correlate their return with their skills and knowledge, while the actual reason is solely luck. Investors are prone to overestimating their ability thus resulting in potential loss.
It was suggested by a research on the Standard & Poor’s 500 index, that there has been a prolonged decrease in the percentage of professionals who can beat the market performance as time goes by. The first year is the most optimistic situation for the investors, where there are 37% of them who can perform better than the index. However, the figures keep sliding down which eventually leads to 8% in year 15. Now you may guess, one of the reasons that explains all these happenings is because of cognitive biases. There are 5 common types of those, namely Loss Aversion, Bandwagon, Recency, Anchoring and Confirmation Bias.
1. Loss Aversion Bias
These types of investors are strongly loss reluctant, so when they encounter the equivalent level of return and loss, it would be more challenging for them to bear with the loss.
2. Bandwagon Bias
This belief is relatively more common and familiar. It conveys that investors conform to the social norm that in turns neglect their own true needs.
3. Recency Bias
We usually rely on the recently received information, such as if investors think the stock market has been flourishing, they would be over-optimistic when predicting the performance for the next few months.
4. Anchoring Bias
While information overload is occurring in this cyber world, Anchoring Bias means that we tend to utilise the first chunk of information when making decisions.
5. Confirmation Bias
This type of bias indicates that we are used to taking in that information which supports what they already believe.
After getting ourselves warmed up with the various categories of cognitive biases, next week we are going to explore the ways of how they intrude our decision making process. Stay tuned!