3 Cognitive Biases in Investing That You Should Be Aware Of

We think less rationally than we think we do

Louis Petrik
Aug 2, 2020 · 5 min read
Investing Biases Stock Markets
Investing Biases Stock Markets
Photo by Jp Valery on Unsplash

For some, investing in the stock market consists of buying and selling.

Others deal intensively with key figures of the companies and make their purchase decisions based on these.

Then some are very relaxed about investing in products such as ETFs to be invested in various stocks at the same time.

All in all, it makes sense to invest in the stock market.

Even if you do not have a significant income, it is, fortunately, possible to invest very cheaply nowadays. Above all, it makes sense to start investing at a young age, because your assets will have more time to grow — compound interest effect.

So that you too can invest effectively and rationally, here are a few biases that you should not fall for — they apply to almost every financial product on the stock market, whether you want to invest in individual shares or in index products ETFs.

The Home Bias

Many equity investors invest only in the shares of companies they know themselves or only in the share index of their country or region.
In my opinion, it’s perfectly understandable, and there are a couple of reasons why people love to invest in domestic stocks:

  • They know the companies, their products & are convinced.
  • They know the political and economic conditions surrounding these companies best.
  • They like these companies; they are customers themselves.
  • They hear in the media and from other people most about the domestic companies — so they are also more likely to receive investment recommendations regarding these companies.

But this is exactly where the mistake lies.

Even if you naturally know the companies from your country better, have more connection to them & trust them more — return comes from risk.

And so it makes sense to invest internationally, not forgetting emerging markets.

Therefore it does not make sense to invest only in the shares of the home country or a larger region/continent. A good portfolio can and should be invested worldwide. Even if the domestic and established companies seem safer and perhaps are safer, there is still only an unnecessary cluster risk — if a crisis really does occur in the relevant region, the damage is immense.

Not to mention the returns that can be achieved by investing in effectively weaker regions worldwide, i.e., emerging markets. Investing in these, for example, through an index such as the MSCI World Emerging Markets, has yielded higher returns in the past. Yes, I know past returns do not guarantee returns, nor do they here. Nevertheless, we can expect profits to remain high in these regions, simply because the investment risk is correspondingly higher. So make sure that your equity portfolio is not only invested worldwide but also that a share of about 15–30% is invested in emerging markets.

The Bias Of Thinking That Past Returns Determine Future Returns

Important: This does not apply per se.

A higher return can almost always only be explained by a higher risk — consequently, low-risk investments are also low-return.

The simplest example: your own money in the call money account, or cash under your bed — almost entirely safe, but also no (in the case of call money only little) return.

So there are asset classes that have a high past return, a higher return than the average market. And that will probably remain so because the risk of these investments is higher. The MSCI World emerging markets index is a good example of this is. But returns are never guaranteed for the future.

Why results of the past are worth nothing — Regression to the mean

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Source

Statically speaking, there are always swings in prices, e.g., the prices of entire stock indices. On average, the German share index DAX has generated an annual return of approx. 6%. But in some years, there was no return at all, in some years even double-digit returns. These are the swings I was talking about, which will occur again and again. But in the long term, the return will always level off against the average.

So we basically remember that there are always upward and downward swings. So it could be that we are only on one of them again at any given time, and the next one is down — past returns do not guarantee anything, the only thing that is certain is that the international stock market only tends to rise.

The Anchoring Bias

Who doesn’t know the feeling: You want to buy some stocks of a company or even a more complex product like an ETF — but what you want to invest in is currently at an all-time high.

The NASDAQ-100, for example, which is currently at an all-time high despite the corona crisis or the Apple stock.

And what do you then often think, as an investor who knows that there are highs and lows? “I’ll just wait for the price to drop, then I’ll buy it.
And two months later there’s another all-time high. Too bad.

What keeps us from buying is the anchoring bias.

The anchor is the current price at the all-time high, which makes everything before it looks like an optimal entry price, but is not one itself.
That’s why we prefer to wait — because we think that another dip is bound to come.

But that is irrational thinking.
Sure, there are highs and lows in share prices, but as we discussed above, after these swings, share prices return to average growth.

So these are the problems:

  • Even if there are dips, we cannot predict when they will come.
  • There’s no guarantee that the dip will be strong. After all, the stock markets are growing steadily, so the dips are not as strong as the ups and downs, or there is constant growth.
  • So it is possible that even after the dip, the price we thought was too high weeks/months before is lower than the current one right after the fall. After all, there is a tendency for growth.

It tends to be irrational to wait for the next dip, even if there is one, the return does not have to be much higher & does not play a significant role in a long-term investment period. The emphasis is on “tends to be.”

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions

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Louis Petrik

Written by

Finances, Programming & Psychology. Figuring out life, one idea at a time.

Making of a Millionaire

Stories about money, personal finance and the path to financial independence.

Louis Petrik

Written by

Finances, Programming & Psychology. Figuring out life, one idea at a time.

Making of a Millionaire

Stories about money, personal finance and the path to financial independence.

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