Three investment biases you should avoid to meet your financial goals

Confirmation Bias

In his book The Art of Thinking Clearly, Swiss author and businessman Rolf Dobelli, termed this bias as the "mother of all misconceptions". Confirmation bias is the tendency to interpret new information in a manner that it becomes compatible with our existing beliefs and theories.

To put it otherwise, any information that contradicts our views is filtered out. If taken to an extreme, it can sap your ability to think objectively and independently. It makes you overconfident, resulting in a false sense of security where you can't seem to go wrong with your investment decisions. This, in turn, elevates the risk of being blindsided, when things actually go wrong.

The fundamental reason why investors suffer from this bias, is because we as human beings, desire to minimise cognitive dissonance or the psychological stress that accompanies decision-making, when we take into account information that contradicts existing beliefs. However, when it comes to investments, this bias makes you adopt a myopic approach, which can be detrimental to long-term wealth creation.

Herd Mentality Bias

A bias with pre-historic roots, it refers to an investor's tendency to copy what others are doing, being largely influenced by emotions and instincts rather than their own independent analysis. Recall the dotcom bubble when several investors bought stocks simply because everyone else was doing so, despite many companies lacking sound-business models.

Before jumping to conclusion or joining the fray, take time to analyse if the investment or stock aligns with your financial goals and most importantly, your risk appetite. Is your risk tolerance the same as that of a pro? If not, step aside, focus on your goals and estimate your risk-taking capability to invest accordingly.

The perils of falling prey to this bias has been aptly summarized by Warren Buffet - "Be fearful when others are greedy and be greedy when others are fearful." So, the next time you feel you need to bet on a particular stock chosen by your peers, know what's guiding you and adopt due diligence, before you decide to jump.

Recency Bias

The tendency to extrapolate current experiences to future possibilities, leads to this bias that can have disastrous consequences. In investment parlance, what happened yesterday may not be replicated today or even, tomorrow.

Recency bias skews truth, leading to poor decision-making. However, more often than not, we end up giving more importance to recent developments, rather than looking at the big picture. A long-term trend is ignored, in favour of the most recent one.

As pointed out by American journalist Jason Zweig in his book Your Money and Your Brain, it's a common human tendency to estimate probabilities based on a handful of latest outcomes, rather than paying heed to long-term experience. Recency bias leads investors to bet on stocks based on their current performance, ignoring past history. This can lead to wrong choices, bringing down the overall value of the portfolio.

An easy way to overcome this bias is to adopt a practical approach and evaluate long-term performance. Also, stick to your selection criteria and don't let emotions cloud your judgement.

To sum up

As father of value investing Benjamin Graham observed, an investor's major problem and worst enemy is likely to be himself. Overcoming these biases will go a long way in promoting self-discipline and mitigating these cognitive behavioural handicaps.

The author is Head of Personal Wealth Advisory at Edelweiss Wealth Management.

Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.