Investors often find emotions to be their most significant hindrance.
In the world of investments, it's crucial for investors to be aware of their own biases and strive to neutralize them, according to Michael Blümke, a portfolio manager at Ethenea. This advice is particularly relevant today, as Blümke believes Graham's analysis on the subject remains highly pertinent.
Two of the most well-known cognitive biases in investing are confirmation bias and hindsight bias. Confirmation bias is a cognitive bias where investors select and interpret information to confirm their existing beliefs, potentially leading to poor decisions due to a lack of balanced perspectives. Hindsight bias, on the other hand, overestimates the ability to predict future events with the knowledge of past outcomes, which can cloud judgment by not adequately considering the underlying causes and reasons for the event.
Loss aversion bias is another emotional bias that investors should be mindful of. This bias leads to irrational decisions, as investors tend to perceive losses as having a greater impact than gains of the same magnitude. In investing, loss aversion bias results in investors acting risk-averse when realizing gains and risk-seeking when incurring losses.
To avoid such mistakes, Blümke recommends clear investment rules, thorough documentation, and an objective investment strategy. He emphasizes the importance of understanding position sizes, risk budgets, and diversification. Furthermore, investors should not become emotionally attached to investments and consider other opinions besides their own.
Behavioral economists Daniel Kahneman and Amos Tversky's prospect theory explains this phenomenon further. Their theory posits that people perceive losses as having a greater impact than gains of the same magnitude. This is why an investor facing a 100 euro loss feels regret much more strongly than the joy of a 100 euro gain, despite their economic equivalence.
Benjamin Graham, known as the father of value investing, identified distorted judgment and personal biases as the greatest enemies of investors. Cognitive biases in investing occur when investors rely on established concepts while ignoring statistical errors or inaccuracies. In challenging market conditions, investors should consistently limit losses, preferably using a predefined rules system.
By being aware of these biases and taking steps to neutralize them, investors can potentially avoid making poor decisions and rob themselves of potential returns. It's essential to remember that in the realm of investing, an objective and well-informed approach is key to success.
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