Cognitive biases can lead investors astray, but here's what you can do to overcome them.
By Josh Goulding
Humans like to think of themselves as rational, and economists have historically modeled the markets with the assumption that people will act rationally. Instead, investors tend to react to market movements with a range of biases, from overconfidence to costly loss-aversion bias.
Behavioral finance, pioneered by Daniel Kahneman and Amos Tversky, challenged the steadfast belief that markets are driven by classical economic theory.
This past year was marked with pronounced emotional moments where investors went from feeling like it was 1929 in March 2020, to feeling like they were experiencing the 1999 market euphoria in January 2021.
One of the most important things you can do as an investor is to understand ingrained psychological biases. Being aware of these biases can help prevent poor decision-making during emotionally charged moments. Here are three biases to be aware of and how to combat them:
- Overconfidence bias
- Loss aversion
- Confirmation bias