Finance professors are significantly more likely than others to invest in equities. Finance professors are also “less prone to behavioral biases because their decision not to invest in equities is based on either the outcome of their past investments nor their short-term expectations of the market.” So, what do finance professors know about overcoming biases that the rest of us can learn to become better investors?

Loss aversion. Also referred to as ‘regret aversion’, the negative feelings associated with a loss are significantly greater than the positive feelings derived from a gain of the same size which can lead investors to hold on to a losing investment. By holding on to a losing investment, investors can avoid realising their loss (but let the loss spiral) and confronting their own poor decision-making.

Manage your aversion to losses, by setting a ‘stop’ before you invest. A ‘stop’ is a pre-determined price (with a high and low option) at which you agree to sell. With a  pre-determined sell stop, you’ll be less likely to be swayed by your emotions when you see your investment tank or rocket.

Overconfidence. Overconfidence implies that you have a strong belief in your ability to win in a situation where chance and other participants are involved. For example, most drivers believe that they are safer than a typical driver. When you’re overconfident as an investor, you’re more likely to trade more than your peers which can mean more brokerage fees over the long-run. As an overconfident investor, you may also believe that you can time the market.

There can be upside to overconfidence when applied to entrepreneurship though: “Those who are overconfident about their own perceptions or abilities, or perceive risks as smaller than they actually are, may also be more likely to veer away from usual or accepted group perspectives, which can foster innovation.” (Bernardo and Welch 2001)

To prevent overconfidence as an investor, you should remind yourself that there are professional fund managers with access to investment research, industry reports and mentors, who struggle to consistently achieve returns above the market average. Have a plan before you invest (like investing in index funds) and try to avoid jumping in and out of the market regularly.

Self-attribution. People who experience successful outcomes regard it as a result of their own skill, but blame unsuccessful outcomes on bad luck (Shefrin 2000). Similar to overconfidence, self-attribution bias encourages investors to take on an inappropriate amount of risk and overtrade.

Hindsight bias. The tendency to believe with hindsight that something that has already happened was highly predictable, even when there would have been little basis beforehand for such a belief (Roese and Vohs 2012).

To avoid being blinded by hindsight bias, read Black Swan by Nassim Nicholas Taleb. Taleb poses the Black Swan theory that an event that comes as a surprise and has a major effect is often rationalised after the fact with the benefit of hindsight. By believing that an event is more predictable than it was, can result in an investor oversimplifying cause and effect when considering their next investment.    

House-money effect or break-even effect. Thaler and Johnson (1990) argued that “an investor is willing to take on more risk after experiencing a gain because he believes he is using the house money (house-money effect).” They also described the break-even effect: when an investor is “willing to take on more risk after experiencing a loss because he is trying to recoup his prior losses.” Both effects encourage investors to take on more risk than may be appropriate.

Having a plan before you start investing can help overcome these effects. You can enter the stock market by deciding on your asset allocation (how much you put in stocks, bonds and cash) and timeframe. A long time-frame of at least 10 years can help prevent you from being discouraged by the short-term volatility of your investments and allow your investments to grow. You won’t be tempted to overtrade when you adopt a buy and hold approach.

Cognitive dissonance. People experience stress when confronted with information that calls existing beliefs into question, and thus try to avoid facing such belief-changing information. If you hold stocks in a company that you believe has strong growth prospects, you may disregard information that shows the issues faced by said company.

If you invest in individual stocks, be sure to do your research before investing. Are the stocks undervalued and is there real growth potential for the company?

In short, it’s important that you have a plan before you start investing. Yes, you’re still a human being with emotions but, having a plan helps you from making snap decisions when the media tells you to sell all your stocks. Happy investing!

* This is not a sponsored post*

Photo by Utomo Hendra Saputra on Unsplash.

WRITTEN BY MAUREEN MCGUINNESS

Maureen McGuinness is author of Your Money, Your 20s: Sow the Seeds of Wealth. After googling "save money" as a teenager, she has been researching and writing about personal finance for over a decade. During university, Maureen noticed a distinct lack of money advice and resources for 20-somethings. Keen to invest in the stock market, but unsure how to, Maureen read several books on investing during her time at university and had an investment plan for the day she started her graduate job. She is interested in the psychology of money and uses research in habit formation to help others to feel more empowered with sound money management. 

After spending a few years in a well-paid corporate career, Maureen decided to move to part-time administration work and freelance roles as a professional tennis umpire and TV extra to provide her with the flexibility to write on personal finance. By following her own money advice and embracing a minimalist lifestyle, she has more freedom to work on her passion: getting young women excited about the freedom provided by solid money management.

Maureen McGuinness is the author of Your Money, Your 20s: Sow the Seeds of Wealth ebook available on Kindle and in all formats at Gumroad and two courses on e-mail platform, Highbrow, Financial Wellbeing: How to Worry Less About Money, and Personal Finance Concepts. Get 50% off her Highbrow Course and other premium courses on Highbrow for a year ($24 with the discount) by using this code: MCGUINNESS50OFF.  You can read more of Maureen’s articles at The Life-Life Balance.