What Are Cognitive Biases?
Cognitive biases are mental shortcuts (heuristics) that our brains use to simplify information processing. While often useful in everyday life, they can lead to irrational decisions and significant errors in the complex world of investing. Being aware of these biases is the first step to mitigating their impact.
Common Cognitive Biases in Investing
- Confirmation Bias: The tendency to search for, interpret, favor, and recall information that confirms or supports one's preexisting beliefs. An investor might only pay attention to positive news about a stock they own, while ignoring negative news.
- Overconfidence Bias: The tendency for a person to overestimate their abilities. An overconfident investor might trade too frequently or take on too much risk, believing they can outperform the market.
- Anchoring Bias: The tendency to rely too heavily on the first piece of information offered (the "anchor") when making decisions. An investor might be anchored to the purchase price of a stock, making it difficult to sell a loser.
- Herding: The tendency for individuals to mimic the actions of a larger group. This can lead to buying into market bubbles or panic selling during a crash.
Overcoming Biases
Overcoming cognitive biases requires a conscious effort to be more disciplined and systematic in your investment process. This includes creating a detailed investment plan with predefined rules for buying and selling, keeping a decision journal to review your thought process, and actively seeking out opinions and information that challenge your own.
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