2 Psychological Biases That Are Killing your Returns
How These Biases Affect Your Investment Decisions...And What You Can Do About It
Introduction
Over the past few weeks, I was catching up with some friends. One of the topics that were brought up included the concept of stock prices. They were complaining that certain stocks are too highly priced, making it unattractive as an investment. Some common statements included things like “Amazon is so expensive”, it costs $3,000 per share. Why don’t I buy xxx stock selling at $10 instead? This way I can buy more shares.”
If you’ve heard of this before, or know someone who have made these statements before, you need to read this.
Many factors come into play when evaluating a stock, not just the nominal price. There are 2 types of price anchoring biases (which I think are the most common).
“High Price” Bias
The first bias is what I term the “high price” bias.
Many people do not want to get into certain stocks/ crypto due to the perceived “high price” (in nominal value). Stocks like Google (GOOGL) and Amazon (AMZN) all cost thousands of dollars for a single stock. Instead, they prefer to dabble in more speculative “cheaper” stocks. The same goes for crypto. Instead of going for the big 2 in Bitcoin (BTC) and Ethereum (ETH), they would rather buy “cheaper” altcoins in the hope that they could go to the moon.
While there are some amongst these supposedly “cheaper” alternatives that could do well, it is actually hard to identify which one. Trying to identify the next big thing is equivalent to attempting to hit a home run. It is definitely possible but the probability of it happening is low.
“Averaging Up” Bias
The second bias is what I call the “averaging up” bias.
There is an old saying in the investment business,
“Be careful you don't pick your flowers and water your weeds”
I have seen many people fall victim to this. When the stock price continues to falls, they keep buying more and more, thinking they are “averaging down”. When the stock price rises, they sell to “take profits”. What really happens is that you are compounding their losses.
Of course, there are exceptions to the rule. There are times when good fundamental stocks fall in the short term (and it’s okay to accumulate in this instance). It all comes down to the fundamentals of the investment. If the stock you purchased is a fundamentally strong business, then it’s okay to buy when it falls.
Psychologically, it is very difficult to buy in when the stock is above your purchase price. More often than not, this increase is attributed to the fundamentals of the stock. If you find yourself in this situation, chances are the stock you’re holding is a good one.
How Does Anchoring Bias Affect Our Investment Decisions?
Anchoring bias indicates that an investor makes decisions based on the initial information or relies too much on the recent information that obtained. This draws investors to a reference point (i.e. price) which is not relevant to the investment decision at hand.
Focusing too much on price hinders us from properly evaluating the investment opportunity on offer. This may lead us to make less than optimal decisions for our investment portfolio.
How To Avoid Price Anchoring Bias?
To avoid price anchoring bias in investing, we have to be self-aware. This means being aware of its existence in the first place, and how it is affecting us.
There’s only ONE way to avoid this bias, which I bet you already know:
Do your own due diligence and research.
Here’s what you should NOT do (which many are doing):
Analyst forecast /expert opinion about any particular industry or company
Hearsay from family and friends
Once you start to develop the habits of independent thinking and research, you’ll stop anchoring to price points and focus on fundamentals instead.
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