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winner's curse- investing psychology

Investing Psychology: Winner’s Curse

Investing Psychology- Winner’s Curse :

Have you ever had a chance to participate or witness an auction?

If yes, then you would relate to this better! As interesting as the name of this phenomenon sounds, the outcomes are pretty relatable too.

Many statisticians, mathematicians, and successful investors have discovered and scribbled a pretty common sequence of scenarios that happens mostly during the auction. Let’s try to give you an overview of this:

A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.

As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”.

But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.

Such scenarios are quite noticeable everywhere – from IPL auctions to jewelry auctions to the real estate to the stock market, you might get to see this every time. The phenomenon could be explained clearly with the use of a couple of suitable examples in this article.

“Winner’s Curse” is quite noticeable in the domain of investing. Generally speaking, a newbie tends to fall in such pitfalls quite often! Keep reading this article to know more about the winner’s curse!

Also read: How to Earn Rs 13,08,672 From Just One Stock?

The Auction Scenario:

If you haven’t had a chance to witness an auction yourself then you have a chance to virtually experience it over here!

Basically, an auction is a set up organized by the “current owner” of an asset who is interested in selling the asset to one of the bidders who are participating in the auction. The owner can be a bank or any other financial institution as well.

A set of people who are interested in purchasing the “on sale” entity are called bidders who have the leverage of placing the bids on the entity. The bidding starts with a base price (the one put forward by the “current owner”) and the bidders have to one-up their biddings to own the asset/entity.

The mentioned set of actions is repeated until no bidder out rules the last bidding. As a result, the final bidder gets the asset – sound simple?

Where is the loophole?

Suppose if the real (true value) price for the asset was 1 hundred thousand dollars and if the final bidder claims it for two hundred thousand dollars, would he still be called as a winner?

Psychologically speaking, the overwhelming and competitive environment of bidding in an auction makes the bidder claim the entity at a higher price than what is profitable (admissible).

This overestimation of the final bid for an entity is actually the cause of “winner’s curse”.

winner's curse graph

New to stocks? Confused where to begin?  Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount. 

What triggers this curse?

They say, “Emotional stability is one key factor when it comes to investing”.

You would have seen various collaborations of multinational companies. In fact, the whopping amount for which the shares for a certain company get sold is quite huge, right? Well, the winner’s curse is actually playing the cards for it sometimes.

In fact, various multinational giants get caught in this trap. Is it emotional friction or winning at any cost? I’d say both.

The human brain works in a pretty competitive way and the reason can be delved into the core of cognitive science. After the “successful bidding” one gets to realize the loss incurred but the dust gets settled by then.

A rapid increase in an entity’s price followed by its contraction is a sequence followed by various financial experts. The strategy works when a number of people get lured by the so-called “lower prices” of the assets and end up paying for it.

Also read: Efficient Market Hypothesis -The Only Theory That You Need to Read Today.

Winner’s Curse in the Stock Market:

Winner’s curse is not new to the stock market. You can notice multiple scenarios in the stock market where the investments of the people are influenced by the winner’s curse. Few of the best examples are:

1. Buying stocks at a high price.

In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is never advantageous for the investors.

2. Investing in IPOs where the insiders are selling their stakes and public is bidding.

IPO is a scenario where a company offers its shares to the public for the first time. During an IPO, insiders like Promoters, Family, Early Investors- Angel capitalist, Venture capitalist etc are selling their stakes to the public.

However, do you really think that the insiders will sell their stakes to the public at a discount?

Anyways, in order to win, the public is ready to bid a high premium (most of the time) for that IPO. However, after the IPO gets allotted to the people, the winner’s curse starts playing its role.

Also read: Is it worth investing in IPOs?

stock market bidding

You might want to steer clear of this the next time you go for a hefty investment, right? Don’t worry you can try out some precautionary measures with which you should do fine at the “war zone”.

Things to Remember while Bidding:

1. Just as analysis and research are two important things to do before making an important investment. Similarly, knowing the true value of the asset you are bidding for is quite important before you even go for it. You should know that you stick to your actions even better once you have the basics cleared in mind.

There must be a fair standard price of the commodity you’d be bidding for. Get to know about it beforehand.

2. Draw a line: Putting aside an emotional mindset is the best thing that you can do while bidding for an asset as emotions and finance don’t mix well together. As soon as you start placing your first bid, you should know where to draw the line. This would help you hold your grounds in a much better way.

3. Know how important it is for you to win: Rational arguments are always better when you are in a confused state of mind. Ask yourself why does winning actually matter to you?

Also read: Loss Aversion- How it Can Ruin Your Investments?

5 Common Behavioral Biases That Every Investor Should Know cover

5 Common Behavioral Biases That Every Investor Should Know.

5 Common Behavioral Biases That Every Investor Should Know.

Ever heard of Tech gender problem? It is a situation where the employer favors male candidate over female thinking women are no good at tech because they are women.

Even one of the biggest companies in the world, Amazon, faced this bias. (Read more here: Amazon’s machine-learning specialists uncovered a big problem: their new recruiting engine did not like women — The Guardian.)

Anyways, gender bias is nothing new. Throughout history, when jobs are seen as more important or are better paid, women are squeezed out. And similar to this one, there are multiple common biases that we can notice in our day to day life.

But, what actually is a bias? — According to Wikipedia,

“Bias is disproportionate weight in favor of or against one thing, person, or group compared with another, usually in a way considered to be unfair.”

In other words, it is an inclination or preference that influences judgment from being balanced. Biases lead to a tendency to lean in a certain direction, often to the detriment of an open mind.

Behavioral Biases in Investing:

Investors are also ordinary people and hence they are subjected to many biases which influence their investment decisions. Although it takes time to control the behavioral biases, however, knowing what are these biases and how they work — can help individuals to make rational decisions when they are susceptible to these situations.

In this post, we are going to discuss five common investing biases that even investor should know.

Confirmation Bias

When a human mind is determined towards one particular behavior, it subconsciously rejects the pieces of evidence against it while confirming the ones that go in its favor. This is known as confirmation bias.

Psychologically speaking, an investor would be more inclined towards his pre-occupied information and knowledge about certain kinds of investing. While considering the pros and cons of a certain kind of investment, the buyer would most likely go with what he used to believe until now.

For example: Making an investment in Bitcoin is dangerous and pointless. If this is an investor’s pre-occupied notion then he would most likely not invest in bitcoins in future.

Gambler’s Fallacy

Gambler’s Fallacy is one such proof which states that a human mind often interprets the outcomes of a future event judging by its corresponding past events even if the two are completely independent of each other. It is inspired by the “failures of gamblers” due to their probabilistic illusions to make decisions in casino games.

Gambler’s Fallacy can be very well explained with the help of a basic example involving a coin. For future reference, let’s suppose that the coin is fair with both sides (heads & tails) having an equal probability of landing on top.

Suppose a coin is flipped 10 times and the result of each event was “Heads”. What would you bet for the next coin flip?

Now, if a human bet on the outcome of the 11th flip of the coin to be “Head” seeing the past events, then it can be considered a bias.

The above context does only imply a simple rule: The occurrence of an independent event is not dependent on past events. In this example, the 11th flip of a coin would result in both heads and tails with a 50% chance of being associated with each one of them.

Buyer’s Remorse:

The regret after purchasing a product is called a buyer’s remorse. Here, the buyers may regret that either they overpaid for the product or they didn’t actually need that product.

Nevertheless, purchasing commodities are not the only thing where people feel “buyer’s remorse”. Stock investors are also like ordinary people, and they too feel this remorse after purchasing equities.

“Was buying this stock a mistake?”

“Was my timing right?”

“Did I just buy a lemon of a stock?”

“Is the market going to collapse?”

“What if I lose money?”

In general, investors feel remorse when they make investment decisions that do not immediately produce results.

Herd Mentality:

An investor’s natural instinct goes with the ones of masses, which means that he/she doesn’t seem to have a rational view on a certain investment but is more likely to deviate where the majority mass is moving — this little phenomenon is known as the “Herd Mentality”.

The term has been derived from the natural instinct of a number of sheep walking together in a herd so as to avoid falling into the pitfalls of danger.

Interestingly, you can also find a large population of investing community following herd mentality psychology in making various financial decisions like buying new property or investing in the stock market. Seeing others getting profited with an investment, our brain tells us to go for it without a second thought.

herd mentality

Winner’s Curse

A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.

As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”. But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.

Such scenarios are quite noticeable everywhere, including investing.

In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is most of the time disadvantageous for the investors. Another example of winner’s curse is bidding in expensive IPOs.

Closing Thoughts

Most biases are pre-programmed in the human nature and hence it might be a little difficult to notice them by the individuals. These biases can adversely affect your investment decisions and your ability to make profitable choices.

Anyways, knowing these biases can help you to avoid them causing any serious damage. Moreover, a good thing regarding these biases is that — like any habit, you can change or get over them by practice and efforts.

Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst. I’m 23-year old and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting

buyer's remorse cover

What is Buyer’s Remorse? And how to deal with it?

What is Buyer’s Remorse? And how to deal with it?

Have you ever bought a new pair of shoes that you’ve been planning to buy for a while, but started regretting the purchase as soon as you arrive home? Maybe it was the best deal in the last three months, and you got a discount of over 30% on the original price. Still, you can’t stop thinking that you might have overpaid for that shoe. Or you might start presuming that you didn’t need a new pair of shoes at all and you have wasted the money on it ‘unnecessarily’.

This regret after purchasing a product is called a buyer’s remorse. And don’t worry, you are not different. It happens to everyone.

Nevertheless, purchasing commodities are not the only thing where people feel “buyer’s remorse”. Stock investors are also like ordinary people, and they too feel the buyer’s remorse after purchasing equities. Anybody who has been in the market for a long time might have already experienced investor’s remorse.

In this post, we are going to discuss what actually is buyer’s/investor’s remorse and how one can deal with it.

buyer's remorse pic-min

Investor’s Remorse

Investors sometimes feel remorse when they make investment decisions that do not immediately produce results. The guilt is more prominent when the share price starts going down.

Here are a few general questions that come in the mind of every investor in such situations:

“Was buying this stock a mistake?”

“Was my timing right?”

“Did I just buy a lemon of a stock?”

“Is the market going to collapse?”

“What if I lose money?”

Moreover, the investor’s remorse become stronger when people watch the latest news. The TV analysts/anchors make the current facts (which were not available at the time of investment) look so obvious that people start regretting their decisions at once. However, it is always easier to see into the past than to estimate the future. As Warren Buffett used to say:

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

There’s a very fair chance that you might have taken the best decision based on all the available information at the time of your investment.

Also read:

Buyer’s Remorse Effects

In general, there can be two effects of the buyer’s remorse.

  1. Impulsive decision to return (or sell) the product which may be well reasoned and a smart idea in the first place.
  2. Justifying the investment and refusing to accept the mistake.

Both these effects can be adverse for the investors.

Leaving your position in a well-researched stock just to get over the guilt is never a good idea. On the other hand, becoming adamant on your investment decisions may be damaging for your portfolio and will prevent you from learning a valuable lesson.

Ways to deal with Buyer’s Remorse:

The best way to deal with buyer’s/ investor’s remorse is to re-examine your purchase (both risks and opportunities).

Stand with your stock if the fundamentals are the same and the reasons for purchasing that share is still valid. On the other hand, if you made a mistake, then fix it.

Here are two additional ways which can help you to avoid buyer’s remorse:

  1. Avoid impulsive buying or selling: It’s always a better approach to research intensely before buying or selling. Taking an informed decision will build confidence towards your investments, even if they do not show short-term results.
  2. Have a margin of safety (MOS): If the calculated intrinsic value of a stocks turns out to be Rs 100, then give your calculations a margin of safety of 20–30% and purchase the stock only when it is trading at a price below Rs 70–80. Having a MOS while buying shares will mitigate the risks and safeguard your investments. (You can use Trade Brains’ online calculators to find the intrinsic value of the stocks).

Final tip– Always remember that buyer’s remorse is natural and inbuilt human psychology. But acting or reacting to this guilt depends on the person. The ability to handle buyer’s remorse will make you a better investor.

Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst. I’m 23-year old and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting

the law of small numbers cover

What is the Law of Small Numbers? Meaning, Examples & More.

What is the Law of Small Numbers? Meaning, Examples & More:

Often we don’t realize but the game of investment can be closely connected with hardcore psychology. You must have heard many people say: research before you invest.

While that is absolutely true, you must also know what to research for. While being on a searching spree, generally, you find many online (or offline?!) resources which tend to favor a kind more than the other. Enter, The Law of Small Numbers.

A data has multiple dimensions and each one of them is responsible for inferring the data in a different context. Statisticians tend to choose the attributes (read dimensions) very carefully. The choice of attributes is not random, of course. A couple of data mining techniques such as “Decision Tree Induction” can carry out specific attribute selection methods to take exact inference.

Coming back to the real context, “The Law of Small Numbers” is actually a law confirming fallacy. It says that the length of data is an important consideration for a data as the probability of it being relatable is directly correlated to the length of the data. Read more of this article to get to know about “The Law of Small Numbers”.

The Loophole in the Probabilistic Inference:

Imagine our whole world running on the rules of probability! However fancy it might seem, it is not actually possible otherwise you would be having a fair chance to everything, wouldn’t you? The point is that probabilistic results are always relative. You can neither expect nor confirm the extent of its reality.

The source of the data that you are picking for your hypothesis and inference is of great importance here. Rather than completely shifting your focus to what does a data infer, you might want to shift your focus to where the data has been picked from (and possibly how).

Random Sampling is one of the famous probabilistic sampling techniques which goes with a very basic rule: Each element has an equal and a fair chance of getting picked. Now, nothing in this world is absolutely defined by itself and so the fair & equal chance is quite a hypothesis.

Also read:

Causal Explanation/Causal Narrative:

A Causal Narrative is something which is derived from general human behavior. You must have not realized but we humans have always indulged in pulling out inferences from the pieces of information that are provided to us. The data, however, is not always full-proof.

To put it in clearer words, the data can be churned out as a result of random sampling which makes it even more difficult to put a word to the analysis done through its inferences. You must note that Random Sampling inferences are sometimes misinterpreted as the whole account of the data is not clear and was in fact collected randomly. Similarly, a causal explanation of a data which has been collected or sampled randomly does not always pull out exact inferences.

Why? – Because we are trying to infer a cause for something which has no cause (by its nature).

Hence, equal attention must be paid to the method which has been used for collecting the data.

Sparse Population & an Example:

In a famous statistical puzzle related to kidney cancer among the 3143 counties in the US, the data had two interesting (& confusing) inferences at the same time.

Inference 1: US Counties with the lowest rates of Kidney Cancer have the following attributes:

  • Mostly Rural
  • Sparsely Populated
  • Located in traditionally Republican states in the Midwest, the South, and the West.

Inference 2: US counties with the highest rates of Kidney Cancer have the following attributes:

  • Mostly Rural
  • Sparsely Populated
  • Located in traditionally Republican states in the Midwest, the South, and the West.

Now, how two exactly opposite (in nature) inferences can have exactly the same attributes?

The key attribute or factor here in this example is the sparse population of the data collected in the first place. In fact, a misinterpretation of the data source has been done because of the sparsely populated data as a small population (generated with a random chance) is inclined to show greater extremes in terms of deviations.

Let’s understand this context better in terms of another famous example:

Take an example where a jar of equal red and green marbles is placed and you need to pick 4 marbles out of the jar randomly. The possible outcomes noted are:

  • 2R/2G <- Actual Population Mean
  • 3R/1G or 3G/1R
  • 4G/4R <- extreme outcome (has 12.5% chance)

When the Sample sizes are increased and for example let’s say we’d be picking out 7 Marbles instead of 4 then the probability of extreme deviation (i.e. picking out 7 same colored marbles) is reduced to only 1.8%.

This result is in fact derived from the very famous law –  “The Law of Small Numbers”.

(Credits: Kevin deLaplante)

Conclusion

The law of small numbers explains the Judgmental bias which occurs when it is assumed that the characteristics of a sample population can be estimated from a small number of observations or sample data.

Therefore, while studying any survey, the length of data should be given an important consideration as the probability of it being relatable is directly correlated to the length of the sample.

gambler's fallacy

What is Gambler’s Fallacy? [Investing Psychology]

What is Gambler’s Fallacy? Investing Psychology:

Statistics is always surrounded by two kinds of events – dependent and independent events. While the dependent event’s calculations are governed by different approaches such as the Naïve Bayes theorem and full joint distribution tables, the calculations involving independent events are quite easy to follow.

New technology and data mining techniques are all about using the past data in order to make the predictions true about the future. However, is this always true? Does the future data always depend upon its correlated past data? Even statisticians were not too sure of this.

Gambler’s Fallacy is one such proof which states that a human mind often interprets the outcomes of a future event judging by its corresponding past events even if the two are completely independent of each other.

Gambler’s Fallacy is inspired by the “failures of gamblers” due to their probabilistic illusions to make decisions in casino games. Also known as “Monte Carlo” fallacy, the gambler’s fallacy has been used a number of times for various conformances and inferences.

In this article, we are going to explain the basics of this fallacy and would also consider a few famous examples to understand the term and its context in a better way. Let’s start!

Also read: The First Golden Rule of Investing -Avoid Herd Mentality.

The Coin Toss Example

Gambler’s Fallacy can be very well explained with the help of a basic example involving a coin. For future reference, let’s suppose that the coin is fair with both sides (heads & tails) having an equal probability of landing on top.

Suppose a coin is flipped 10 times and the result of each event was “Heads”. What would you bet for the next coin flip?

Now, if a human bet on the outcome of the 11th flip of the coin to be “Tails” seeing the past events, there’s a 50% chance of him to fail. 

The above context does only imply a simple rule: The occurrence of an independent event is not dependent on the past events. In this example, the 11th flip of a coin would result in both heads and tails with a 50% chance of being associated with each one of them.

Therefore, the prediction of an event can’t be made seeing its past outcomes if the events are independent of each other.

Psychological Thinking & “The Gut Feeling”

Something which our brain is too good at is making inferences. A human brain is very quick at picking up things, assembling them, joining the pieces together, and making an inference. The probabilistic approach here is not always true, however.

A Human brain is just incredible at churning out new patterns and associations that it might create illusions. To put it in plain and simple words:

Our brain can deduce patterns that even don’t exist in reality.

That alone might cause problems and thus exist fallacies like “The Gambler’s fallacy”. In the coin toss example, our brain might work in two ways:

  1. It could think that on most of the coin flips, heads are turning up so, in the 11th flip, it might show a ‘head’ again. OR
  2. It could think that since most of the coin flips have shown “heads” on them, maybe it is going to show the “tails” now.

Both of them, however, are true BUT ONLY COLLECTIVELY.

In the coin toss example, the probability of the 11th flip showing “Heads” and “Tails” is equal and is exactly 50% for both of them.

Also read: Investing Psychology: Winner’s Curse

Gambler’s Fallacy and Investing:

You would think what do these both terms have to do with each other? However, you must know that it is a common practice in the investing domain as well. Investors tend to liquidate their positions (or their bet) over something which is long overdue – again, a classic example of the Gambler’s Fallacy.

For example, if a stock is continuously making new highs for the last 4 consecutive days, few may think that it will correct on the 5th day, so better to leave the position. On the other hand, the rest might argue that it will continue to rise because of the momentum.

An inaccurate understanding of basic terms related to probability can make one invest in wrong places. Now, I would like to ask you the same question again!

In the coin toss problem mentioned above, how much would you like to bet on heads or tails or both?

The correct answer would be to bet half of your money on heads and half of it on tails – pretty simple, right? Not because tails is overdue, not because heads are on a streak but because both of them are having an exactly equal probability of landing on top.

Also read: Get Rid of- Confirmation Bias For Good!

Summing up:

If you pay heed to the name of this fallacy; the gambler’s fallacy, you would relate it to a casino game. The co-relation is justified!

Most of the games in a casino or gambling games have sequences that are randomly generated and are statistically independent. Making a prediction on the outcomes of the events involving the sequence of these games isn’t easy and sadly can’t be derived from the mathematics of probability. Therefore, one would find it purely random and “lucky” to get a winning sequence – the Gambler’s Fallacy is rolling its dice in the background.

Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst. I’m 23-year old and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting

herd mentality

The First Golden Rule of Investing -Avoid Herd Mentality.

Herd mentality is a very common investing psychology seen in most investments done by the people. Here, a majority of past investment done by the mass constitutes a refined data to show inferences.

An investor’s natural instinct goes with the ones of masses, which means that he/she doesn’t seem to have a rational view on a certain investment but is more likely to deviate where the majority mass is moving – this little phenomenon is known as the “Herd Mentality”.

The term has been derived from the natural instinct of a number of sheep walking together in a herd so as to avoid falling into the pitfalls of danger.

herd of sheeps

If you look around, our daily actions are based on this little psychological term that we have just read about. If we break down the context of “Herd Mentality” to its core, we would find out that the concept is more related to “how do the natural instincts work for humans”.

Interestingly, you can also find a large population of investing community following herd mentality psychology in making various financial decisions like buying new property or investing in the stock market. Seeing others getting profited with an investment, our brain tells us to go for it without a second thought.

Why does herd behavior happen?

Although investing collectively is harmful and irrational, however, most of the people choose this tendency because of two basic (human) reasons:

  1. Strong social pressure: Most of the people like to be accepted by a group, rather than branded as an outsider or outcast. Following what the others are doing is a natural way of becoming a member of that group. That’s why following the herd is the logical tendency to avoid social pressure.
  2. Irrational belief that a large number of people cannot be wrong: In general, people believes that the larger the group of people involved in any decision, the lessor is the chance of the decision being incorrect. Again, this is a natural instinct of humans. Until and unless anyone has little experience and expertise of the domain, he/she avoid directly opposing the masses.

Herd Mentality in Stock Market:

Many of the worst financial crisis in the stock market like dot-com bubble or the economic recession of 2008 can be attributable to the same human tendency- HERD MENTALITY. Here are few examples of herd mentality in the stock market from day to day market scenario:

  • Buying a stock which everyone else is buying :

The buying decision of an average investor can be easily influenced by the actions of his friends, neighbors, or acquaintances. Suppose all your friend bought one specific stock whose price is rising day by day. Further, all your friends are making fun of you that you didn’t buy that stock when then initially recommended. What would be the natural instinct of an average investor here?

If everyone around you is investing in a particular stock, then the tendency for potential investors is to do the same. However, this strategy never turns out to be fruitful for an investor in the long run.

herd mentality stocks

  • Investing in ‘Hot’ Stocks

Hot stocks are the darlings of the new investors as these stocks are the ones which are constantly in news and everyone is talking about its upside potential. However, hot stocks become ‘hot’ only when the majority or herd moves their money in this stock after seeing so many other investors doing the same thing.

The ones who are actually going to get benefit from these stocks are the ones who invested in these stocks way before it became a hot stock. The rest (herd) who puts their money in these stocks (when the prices are already high) is going to lose their hard earned money in the stock market.

New to stocks? Confused where to begin?  Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount. 

How to Avoid the Herd Mentality and Make Better Investment Decisions?

It is quite clear by now that judging “collective” behavior wouldn’t do any good when it comes to making an important decision about investments. Most naturally, following what majority of people has chosen is always a tempting and “safe” option to go for. However, without foreseeing the background, one can’t be sure of any important decision.

Jumping on a bandwagon without knowing every bits and piece of details about it is something unnecessary in the investment domain. Before making an investment, make sure that you do the following things:

1. Do your research: A little bit of research never hurts. In fact, this should be one’s habit before making any investment. You can use various references to know the details about any kind of investment you want to jump into. In fact, the more you read, the better it would be.

2. Consult a financial advisor: If you cannot give enough time for the research/study, then why not consult an expert. He/she will be able to give you a better advise compared to your amateur friends or neighbors. 

At last, use your wit to take your decision!

Also read: Loss Aversion- How it Can Ruin Your Investments?

Get Rid of- Confirmation Bias For Good

Get Rid of- Confirmation Bias For Good!

Investing Psychology: Confirmation Bias

“People only listen what they like to listen” is a generic statement which has deep-rooted psychological meanings.

If you consider psychology and investment, both go hand in hand. Since the two are closely related, you would know that one changes (or alters) the effects of the other. One such psychological phenomenon is known as “Confirmation Bias”.

Let’s put this phenomenon forth with an example:

While purchasing a phone online, do you take the efforts to check for its reviews online? If yes, congratulations, you are an intelligent buyer.

However, the point is something different. Suppose that you really wanted to buy this phone for a very long time and have finally managed to have the savings to purchase it. Now, when you are reading the reviews, you would actually consider every positive review about the phone but will mentally decline the negative ones. Sounds familiar?

This concept is related to “Confirmation Bias”. Now, this was a basic idea just to give a glimpse of how this works to our readers. As we will proceed with this article, we will discuss a bit more about the confirmation bias and how it can affect your investment decision.

Human Mind and Biases:

As complex as our human mind is, scientists have been able to infer different phenomena related to the subconscious human mind. The confirmation bias is a result of one such phenomenon. Before moving further, let us discuss – what does the term bias mean?

When a human mind is determined towards one particular behavior, it subconsciously rejects the pieces of evidence against it while confirming the ones that go in its favor.

While we as human beings are found doing this all the time, these actions can be pretty dangerous while making an investment.

Also read: Loss Aversion- How it Can Ruin Your Investments?

Investment and the Confirmation Bias:

Psychologically speaking, an investor would be more inclined towards his pre-occupied information and knowledge about certain kinds of investing. While considering the pros and cons of a certain kind of investment, the buyer would most likely go with what he used to believe until now.

For example: Making an investment in Bitcoin is dangerous and pointless.

If this is an investor’s pre-occupied notion then he would most likely not invest in bitcoins in future. Moreover, the information that will be fed to the investor in favor of this notion would be acceptable to him. On the other hand, the information that would oppose this notion would be rejected by the investor.

bitcoins

Most obviously, this particular bias is not only limited to investment but prevails in almost each and every domain. If you notice closely, the confirmation bias restricts you to consider only one point of view and pushes you to almost reject the others which are lethal to decision making in investment. In fact, in order to make good investment decisions, one needs to consider a scenario multi-dimensionally.

If one fails to do so, he can make wrong investment decisions possibly incurring heavy losses in future.

Also read: Why Nobody Talks About VALUE TRAP? -The Bargain Hunter Dilemma

Confirmation Bias in the Stock Market:

There are various scenarios in the stock market where you can find confirmation bias influencing the investment decision of an investor. Here are few examples:

  • When an investor finds a ‘hot’ stock in any financial website/magazine, he/she will research it further only to prove that the supposed ‘potential’ is real. They might look at plenty of positive news regarding that stock. In the same time, they’ll ignore the red signs, just by making excuses like ‘It’s not going to affect the company much’.
  • If the stock price of a company starts falling, the investors start looking at all the negative flags only. Even if the setbacks are temporary and the company might have a good long-term future potential, however here the investors are more biased to the negative flags and totally ignore the positive factors concerning that stock.

confirmation bias stock market

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How to Avoid Confirmation Bias? 

The easiest approach to avoid confirmation bias while investing it to take an expert advice from a trained financial advisor.

Don’t we always take a second opinion from our friends or colleagues for every little thing we do? Be it selecting an outfit for an important event to taking major life decisions, a second opinion actually helps in backing up our decision. Therefore, you would want your second opinion to be totally unbiased and reasonable, wouldn’t you? That’s what expert advice is for.

Make sure that you ask for an advice from an experienced investor or from an expert financer. An expert advice makes you see the alternatives in a better way.

Nevertheless, with practice and experience, even an individual investor can avoid confirmation bias, without even taking help of an advisor. Here are two important steps that you need to contemplate in order to avoid confirmation bias.

1. Look at each and every dimension: Considering only pros or only cons about an investment would make the information partial (incomplete). Hence you need to view a scenario from different angles in order to make a backed-up decision.

2. Take some time before you pop a decision: Time is an important factor and it actually helps in unfolding various new information with it. An intelligent investor knows the amount of time he needs before he could finalize his decision. 

Conclusion:

Confirmation bias is not new to the investing world and do not regret if you have been following this psychology even without knowing. However, now that you understand that confirmation bias can adversely affect your investment decisions, you need to avoid it.

Although confirmation bias is a human instinct- nevertheless, you can control/avoid it with practice and experience.

Also read: Case Study: How 100 shares of WIPRO grew to be over Rs 3.28 crores in 27 years?