Avoid These 6 Cognitive Biases When Picking Stocks by The Motley Fool


© Reuters. Beginner Investors: Avoid These 6 Cognitive Biases When Picking Stocks

The current market correction (or, arguably, bear market) has tested the mettle and risk tolerance of many investors.

New investors who took advantage of the bull market in the low interest rate environment of the past few years were subject to unpleasant shocks, as growth stocks and the technology sector fell sharply. By overweighting their portfolios to these investments, many of these aforementioned investors displayed a set of investment biases.

An investment bias is an irrational preference that affects a person’s investment decisions and outcomes. We subconsciously know that what we’re doing isn’t for the best, but somehow we convince ourselves that it’s the right thing to do.

Having an investment bias distorts the way we think and prevents us from making the kind of thoughtful, scientifically-based decisions that smart stock picking demands. Instead of making an objective and rational decision on facts and evidence, we emotionally act out of distorted or illogical thought patterns.

Today I’m going to go over six common biases that new investors (including me at one point) typically have. Learning to recognize and avoid them can dramatically increase your yields.

Herd Bias Remember the short push from GameStop (NYSE 🙂 and AMC and how everyone piled on top? Did you feel the same urge? If so, you’ve experienced the breeding or urge to jump on the proverbial bandwagon and be “in” with the crowd. Just because everyone’s in it doesn’t make it more likely they’ll be right in the end. When it comes to the stock market, the majority can often be on the losing side.

Fear of Missing Bias At its peak, GME hit over $400 per share. Investors who bought at the top are now suffering heavy losses as the stock is trading around $90 per share. These investors have fallen prey to fear or lack, or FOMO. FOMO can cause investors to buy pump scams or overvalued stocks that inevitably crash, leaving them with big losses.

Confirmation Bias Go to the Palantir Technologies (NYSE:) subreddit, which has gone from around $26 per share to $7 per share and check out the due diligence (DD) posts there. See how few of them actually make a bearish case for the stock instead of blindly repeating press releases and picking favorable metrics. This is an example of confirmation bias, where investors unconsciously seek out and give more credibility/weight to information that supports their investment and avoid information that might discredit it.

Overconfidence Bias Let’s use Reddit again. Head to the Ark Investors subreddit and scroll through posts two years ago, where posters proclaimed Cathie Woods to be “the next Warren Buffett” and sang about how ARK Innovation ETF would grow even higher. Fast forward to today, where ARKK is now down 57% year-to-date. This is an excellent example of overconfidence, which can encourage investors to make risky and speculative bets, detached from reality and fundamentals.

Recency Bias FANG stocks have performed incredibly well over the past decade. So, it’s a no-brainer to just invest in these winners, isn’t it? A FANG portfolio has historically beaten the S&P 500, so why would it be any different now? This is an example of recency bias. We tend to infer future results from past performance and overweight their importance. However, there is no guarantee that this trend will continue. For example, look at the stock market crash of Meta Platform and Netflix after their recent poor earnings reports.

Survival Bias Investors also tend to focus on investments that have worked well, instead of seeing the often larger group of failures; this is called survival bias. This can lead investors to avoid diversification to bet their portfolio on a small handful of stocks that have a higher risk of failure than expected. For example, one study found that while a handful of market-beating stocks outperform, the majority fail to beat risk-free Treasuries.

The post Newbie Investors: Avoid These 6 Cognitive Biases When Stock Picking first appeared on The Motley Fool Canada.

Randi Zuckerberg, former director of market development and spokesperson for Facebook (NASDAQ:) and sister of Meta Platforms CEO Mark Zuckerberg, is a board member of The Motley Fool. Contributor jerk Tony Dong has no position in any of the stocks mentioned. The Motley Fool recommends Meta Platforms, Inc., Netflix (NASDAQ:) and Palantir Technologies Inc. .

This article first appeared on The Motley Fool


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