Pitfalls That Could Sink Your Investments

investing-worldThere is a definite psychology related to successful investing. Knowing what to do and why makes a significant impact on an investor’s ability to make the right or wrong decisions. What will follow are some tips to help you make more of the right decisions, particularly with regard to having the right mindset. Essentially, most people come with biases that make them simplify decisions that are really more complex than they might appear to be. Here’s how to get around them the way the pros do.

1. Hindsight bias

The hindsight bias essentially refers to the human tendency to look past on events that were beneficial in the past as predictable ones, while looking at bad events as those that were not predictable.

For example, if you correctly choose to invest in no doc loans, you might bias yourself toward believing you always made correct decisions in the past, forgetting the incorrect ones you made in the process.

To reduce the risk and occurrence of hindsight bias, one tips the pros use is to spend a lot of time sitting down and writing out reasons to invest in each stock, as well as the estimated return that might result from each stock. Doing so makes it harder to rewrite the history of your investment through looking at the past with rose-tinted glasses.

2. Groupthinking, or the Bandwagon effect

Groupthinking refers to deriving comfort from a thought process or action due to a belief that other people are doing or believing the same thing. This can be countered simply by choosing not to seek solace in the number of people who are agreeing with you about a course of action.

In the end, what makes you right or wrong is your analysis and judgment, not the number of people in accord with your decisions.

3. Restraint bias

The restraint bias refers to thinking one can show more restraint than one actually can when one is tempted by fate or circumstance. This is seen frequently with people who have eating disorders. This process can be countered by putting risk controls and restraints in place that limit how much you can put into stocks that are considered to be risky.

4. Probability neglect

Probability neglect, or neglect of probability, refers to how people tend to either over, underestimate, or fully ignore the effects of probability when it comes to making decisions.

People tend to oversimplify situations and only think about one or two factors when making decisions and investments. This can be countered by remembering that there is a distribution curve of possible outcomes, and that there are several likely outcomes for any given scenario.

5. The anchoring bias

The anchoring bias refers to how people tend to think too highly of a single piece of information and use it to guide future decisions. It serves as an anchor point that might not necessarily be accurate. It can be countered by looking at present information and not thinking back too much toward past trends and share prices.

6. The confirmation bias

The confirmation bias simply describes how people tend to look for or emphasize information or news that confirms biases or hypotheses they already had. It essentially means looking for proof of things you already decided to believe in. It can be countered or minimized by looking for information that counters your beliefs and theses.

7. The information bias

The information bias is related to paralysis by analysis in that it refers to looking for and evaluating information for the sake of information, even when it really doesn’t help you understand an issue or make a more informed decision. It can be countered by ignoring minute day to day changes in share prices and looking toward longer term trends and comparisons in shares.

8. Loss aversion

Loss aversion frequently impacts people in gambling, which is not unlike the stock market. People tend to prefer avoiding losses, and can focus on this to an inordinate degree rather than pay attention on obtaining gains.

This can be countered by viewing previous decisions as sunk costs, or costs that have been played out completely. As a result, decisions regarding whether existing investments should be held or sold should be compared to opportunity costs in the future, and not toward sunk costs in the past.

9. Bias caused by incentives

Incentive caused biases are the impacts potential rewards can lay on future or present behavior, often in negative ways. This is countered by looking at upsides and downsides rather than looking solely at potential gains.

10. Tendency to oversimplify

Simply put, investors tend to look for simple explanations, even when such explanations are not correct. The way to counter this is to look for complexity and not to simply look for simplicity when striving to understand financial institutions.

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