We began our examination of various mental blind spots that can afflict investors in an earlier piece. We touched on loss aversion, illusory superiority, selective memory and self-handicapping. Having these blind spots will not make us bad investors - but ignoring them will. It is important to self-assess and to recognize natural weaknesses when it comes to our decision-making processes. In part two of this series, will will examine a few more of these pitfalls.
Confirmation bias
Confirmation bias is a tendency to seek out information which supports a previously adopted point of view. In investing terms, this means picking a stock and looking for reasons why it is a winner after the fact, rather than arriving at the conclusion that a particular stock is a worthy value pick after having sorted through a number of suitable candidates. Confirmation bias makes us overvalue information that makes our favorite picks look good, and ignore information that would make us re-evaluate our picks. To make sure we are not falling victim to this blind spot, we need to constantly ask “how could I be wrong?”, or, better yet, ask a seasoned investor to critique our thesis.
The bandwagon effect
Also known as groupthink, the bandwagon effect occurs when one suspends independent thought and begins simply following the crowd. For an investor, this means piling into a stock or other asset while it is increasing in price without stopping to consider whether there is a corresponding increase in value. This is the mechanism by which speculative movements become serious bubbles. Similarly, in times of panic, many individuals will sell their holdings simply because everyone around them is doing so. It is wise in such situations to bear in mind Warren Buffett (Trades, Portfolio)’s adage to “be fearful when others are greedy, and greedy when others are fearful.”
Information bias
This is a bias toward seeking out and evaluating information, even when this information adds no extra value to our thinking. For a prime example of this, look no further than daily price charts, with technical levels that are set and broken several times a day. The financial media is always full of speculation as to why a particular stock went up or down by 2%, when the reality of the matter is that such fluctuations are just statistical noise. By overfocusing on useless information, investors run the risk of making an ill-informed decision or missing something that actually does matter.
Gambler’s fallacy
This bias refers to the mistaken belief that a string of unusual events (say, flipping a coin 10 times and getting heads 10 times) must soon be broken (that tails is "due"). In reality, the outcome of each successive coin flip is independent of all previous coin flips - the coin has no memory. Similarly, stocks have no memory. Just because a stock ended the last 10 days up rather than down does not in and of itself constitute grounds to short it.
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