3 Cognitive Biases That Make You Lose Money in the Stock Market (and How To Avoid Them)
#1: Loss aversion, when avoiding risk means losing every time.
As an investor, I'm sure you've felt like you've made a bad investment. On the other hand, you've had a feeling of euphoria that you've just made a great decision for your money.
This is all normal. In the stock market, your feelings will be tested both ways. This affects both novice and more seasoned investors.
Behavioral finance research has shown that investor psychology is a major source of misjudgment. This is due to cognitive biases, systematic errors in the way we reason and decide. These biases influence all the decisions we make in our daily lives, but some of them are particularly formidable for our financial behavior.
Loss aversion, when avoiding risk means losing every time
For a majority of people, risk-taking is associated with the notion of loss. This implies that these people will tend to never take any risk for fear of losing their precious money.
This reasoning intuitively keeps a majority of the general public away from so-called “risky” investments. These people shy away from investing in the stock market because it represents a risk of capital loss.
However, with inflation remaining at more than 5% in America for several months, investing becomes a necessity to preserve your purchasing power and not lose money. In other words: keeping your money safe from a potential risk of loss is the same as mechanically losing money!
If your brain is misleading you, it is primarily because it is much more sensitive to losses than to gains. Losing $100 affects our brain twice as much as winning the equivalent amount. This is a direct consequence of our fear and protection mechanisms: our primitive ancestors were forced to always prepare for the worst-case scenario to survive in a hostile environment. Today, faced with volatile markets that fluctuate up and down, we focus on the “risk” of losing rather than the prospect of winning.
This way of thinking is wrong and must be corrected.
Historical statistics are clear: the risk of loss in the stock market diminishes over time. Time is therefore your best ally in the stock market. If you invest for one year in the MSCI World Index (representing the world's 1,600 largest companies), your risk of loss is 30%.
If you are patient and move to 10-year investment, this risk drops to 10%. After 15 years of investment, the risk of loss no longer exists!
This means that by taking a long-term view, the upward trend of the stock market is stronger than the short-term fluctuations. You should therefore not confuse volatility with loss. Investing is de facto the only way to avoid losing money due to monetary inflation that wreaks havoc on your purchasing power year after year.
The bias that pushes us to privilege the short term over the long term vision
You keep reading that the stock market favors the patient over the impatient. Yet, many people have difficulty taking the long view.
This cognitive bias can be found in many aspects of our lives, as humans generally favor what gives them instant gratification.
The present bias is a bad natural reflex that you will have to fight to succeed in the stock market. Think of this bias as procrastination. The one that makes us prefer a Netflix party to read a book.
To find out if you suffer from this present bias, try answering this question honestly:
Would you rather earn $1,000 today, or wait 6 months to earn, perhaps, 1,100?
A majority of people will prefer to secure an immediate payoff rather than wait for a potentially higher payoff further down the road. Similarly, many people have a bad habit of looking at the status of their portfolio and then making hasty decisions based on emotion.
Remember that the amount in your portfolio is only a snapshot at a given moment. It does not predict your future profits. The market may be going through a bad patch, but if your assets are solid, you will eventually make a profit as long as you take a long-term view.
Going back to the MSCI World Index, you can see that the average one-year return is 6.8%. In the long term, this gain perspective explodes to 40% in 5 years, 73.3% in 10 years, and 169.9% in 15 years. By investing for the long term, you will also benefit from the magic of compound interest.
It is therefore in your interest to free yourself from this cognitive bias.
The information processing bias makes it easier to be informed than to decide
You are aware of the first two cognitive biases that play tricks on many investors every year. You know about them, but that doesn't mean you can avoid them later.
This is the information processing bias. You can be informed of something, but taking action on it is always more difficult.
You know you have to be patient, but when the market crashes by 30%, you will have a hard time keeping your emotions under control and staying with your long-term vision. However, this is a necessity to take full advantage of the stock market.
Secondly, you must avoid falling into confirmation bias by only taking information that confirms what you want to see happen. You have to be a contrarian investor, to quote Warren Buffett's rule.
Many other cognitive biases come into play when making decisions and taking action. Your role will be to accept that your judgment is naturally biased and to fight against this tendency as much as possible to make the most impartial decisions possible.
Once you have made your choice, you will have to take action by accepting that mistakes always exist. That's the way it is.
Final Thoughts
Everyone needs to invest to protect their purchasing power from monetary inflation. Period. Too many people are still put off investing for the fear of losing money. But as I have shown you, doing nothing is a greater risk than acting.
Once you have integrated this truth, your job will be to try to master your cognitive biases to make the best decisions about your investments. Then, you will have to dare to take action, because, without action, there are no results in life. This naturally applies to the stock market as well.
Some reading
Donald Trump and the Magical SPAC — How To Make $4 Billion in a Few Days From Nothing. This shows the excesses in which the world of finance currently finds itself.
Nigeria Launches eNaira in a Futile Attempt To Combat the Emergence of Bitcoin in Its Territory. The eNaira will not be able to bring to Nigerians what Bitcoin brings to them.
The Land of the Second Chance – How a $4.2B Order Boosted Hertz and Propelled Tesla Past the $1T. Anything is possible in America when the market is full of money that just wants great stories to buy.