Dear Happy Investors, the Biggest Investors Mistakes are part of the investment process. However, knowing how they start and what they are, and how to deal with them will help you to be a successful investor. To be a successful long-term investor, we believe it is crucial to understand the cognitive and psychological biases that often lead unconsciously to poor investment decisions. Biases are ‘hard wired', and we are commonly unaware of the short-cuts that our brain makes. Being aware of your unconscious Biggest Investors Mistakes is fundamental, because it may lead to enhanced risk-return tradeoffs over time which yields higher profits.
In this article, we outline 10 cognitive biases, logical errors, or fallacies that lead commonly to unconscious Biggest Investors Mistakes. We also provide suggestions to reduce and overcome the mistakes.
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Biggest Investors Mistakes 1. Confirmation bias
Biggest Investors Mistakes 2. False consensus bias
Biggest Investors Mistakes 3. Gambler's fallacy
Biggest Investors Mistakes 4. Myopic behavior (shortsighted)
Biggest Investors Mistakes 5. Myopic loss aversion
Biggest Investors Mistakes 6. Selective observations (salience)
Biggest Investors Mistakes 7. Familiarity bias
Biggest Investors Mistakes 8. Bandwagon effect (group thinking)
Biggest Investors Mistakes 9. Overconfidence
Biggest Investors Mistakes 10. Failing to diversify (overconcentration of investments)
You have the tendency to remember, interpret, and search for information in a way that confirms or supports your previously existing beliefs or values. We attach less value to contrary information or opposing views beliefs. Consequently, we are unaware of the weaknesses of mistakes in our investment decision process.
Confirmation bias encourages you to stick to your prejudices and stay in your comfort zone. As a result, you might discard too fast new investment strategies or opportunities. Specifically, you can become too obsessed with one or a few companies and, thus, you ignore the fundamental idea of diversification.
You can reduce your confirmation bias by seeking contrary advice (i.e., create awareness of your confirmation bias) and by avoiding affirmative questions (i.e., do not ask questions that confirm your conclusion about your investment).
Of all the investing biases, the confirmation bias is a persistent one! For example, we also see this recurring a lot in crypto investing, where people get too excited and ignore the facts. The result is that they book substantial losses.
People, and as such investors, have the tendency to overestimate the number of people that will make a similar decision as the decision you have made. Your decision works as an anchor and you seek for confirmation such that you become confident in your decision.
Suppose you go long in Tesla, Inc. How many investors would agree with your decision? When you are asked such a question, experimental evidence shows that you typically overestimate the number of investors that also invested in Tesla. However, many other analysts might conclude that Tesla is overvalued. So, to counteract the false consensus effect always be skeptical of your investment decision and try to avoid seeking for confirmation.
The forum Reddit can reinforce this investment mistake. People get too fanatical in certain topics, leading to meme stocks like GameStop and AMC. The result is that people get in en masse like sheep, even though the stock is vastly overvalued. The downside risk is huge, which means novice investors can lose all their money!
Keep looking at the facts, such as financial ratios and future developments.
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One the most well-known spoilers is the phrase: “past performance is no guarantee of future results.” Inexperienced and unaware gamblers in a casino are prone to think that if the ball hit red 10 times in a row when playing roulette, the 11th time it should be black. Of course, this is nonsense, because each time playing roulette the odds of red and black are identical and independent.
The gambler's fallacy directly holds in an investment context. After a series of losses (gains), investors typically incorrectly believe that future stock performance must yield gains (losses). Be aware that future returns in many cases do not predict future performance (although in some situations there is momentum or long-term reversal possible).
Personally, I try to avoid this investment mistake by investing in unique companies with a sustainable competitive advantage. This strategic position leads to sustainable profitability that is higher than the competition, allowing the company to grow faster than the rest and thus achieve stable growth. However, this does not mean that every now and then you should validate the facts by means of thorough stock analysis.
Investors typically display a lack of patience, which for long-term investors could be devastating. We want to live a good and fruitful life today, and we want to pay debts later. In other words, investors generally care only about short-term performance (e.g., we want a luxurious car today) with no considerations of the future (e.g., we ignore our retirement provision).
To overcome myopic investment behavior, you can set realistic (!) investment goals. For example, by using a target-date fund that pays out at retirement or by committing yourself to more long-term investment products such as ETFs.
With individual stocks, it is advisable to focus on an average annual return, and evaluate it on a five-year basis. After all, stocks are very volatile, but ultimately what matters is the average annual return. Are you actually getting a higher return than mutual funds? If not, it may be smart to switch to funds and ETFs, as these are more passive investments with a lower risk profile.
Also, try to avoid looking at your investment portfolio daily. Why? Read about myopic loss aversion!
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The pain of losing money is twice as large as equal gains. This psychological bias is known as loss aversion and combined with myopic behavior it forms a deadly cocktail. The behavioral finance Nobel laureate Richard Thaler showed that investors who view their investments too frequently (say on a daily, weekly, or even monthly basis) leads them to react too negatively to short-term losses, harming their investment results in the long run.
In other words, if you view your investment performance too often, then you try to correct your losses in the short run, which is unnecessary from a long-term investment perspective. So, avoid looking at your investment results too often.
We see something happening and we immediately think that this occurrence is going to happen more often. For example, you buy stocks from a firm that produces cultured meat (i.e., meat grown in laboratories rather than slaughtering animals) because you think that cultured meat is going to dominate the food industry. Suddenly, you notice how often you see this topic in the news, politics or in research.
It could be that there is a true fundamental interest in this topic, however many of your observations try to confirm what you want and hope to see. The two methods that reduce the confirmation bias also reduce your selective observations!
We like familiarity and habits. Psychologically and evolutionary this makes a lot of sense: if we do something on autopilot, then our brain does not need to waste energy on complex new thoughts.
You might be holding an investment for already a long time, since it feels familiar in your portfolio. But such a familiarity bias can lead to sub-optimal diversification as you stick to your familiar ‘to go' assets rather than exploring new options.
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The bandwagon effect is the phenomenon that we invest in something primarily because other people are doing it, regardless of our own beliefs or values, which we simply override or ignore. This tendency to align our beliefs with those of others leads to herd behavior (also known as group thinking). On a collective level, such herding can be vulnerable to many investors.
For example, the Dot.com bubble around the 2000s: anything that had to do with the internet was presumed to yield high gains, but in fact many firms had no business plans or products. Despite the lack of plans, fundamentals, and vision all these “dot.com-companies” attracted a lot of investors and dollars, which lead to the dot.com crisis.
Three ways to avoid herding are: understand why herding happens (e.g., do all these people have a secret you do not have, or do all these people react on emotion), ignore the crowd (e.g., when people say an investment is great without saying anything about the fundamentals, then walk away) and step back and look at the situation rationally.
Overconfidence is the cognitive bias for people and investors to overestimate their own abilities. Stated differently, it leads you to think that you are a better-than-average investor, which of course simply by the rules of statistics is impossible (e.g., no one can be above average). One of the typical drawbacks of overconfidence is that you make too risky investments.
To counter overconfidence, again give room for the perspectives of other people, such as family and friends. We tend to behave more objectively when we consider the input of others. Another option is to study your past investments and how they worked out. Check whether you have been prone to overconfidence in some situations and what your results would have been if you would have acted more rationally.
The final but key investment mistake is failing to diversify, or to overconcentrate your investments in a particular category such as sector (technology or utilities) or region (North America). The psychological concept of narrow framing (local bias) and home bias are at stake here (as well as the familiarity bias). Especially when you create a portfolio by investing in individual stocks, bonds and commodities ill-diversification is a serious problem, since it leads to a concentration of one particular type of risk (such as only having stocks from developed countries rather than also including emerging markets).
By buying mutual funds or ETFs you can simply overcome the overconcentration of your investments in one sector or region because these products typically invest well-diversified in many firms simultaneously. Please be aware that diversification is key for any investor since it hedges risks in your portfolio.
And, which of these common Biggest Investors Mistakes do you ever make? Let me know in a comment below!