Understanding Behavioral Biases and How They Hurt Your Portfolio
What are the top behavioral biases that crush both traders and investors?
Even the most seasoned in the markets fall victim to behavioral biases. We all experience euphoria, fear, overconfidence, and everything in between.
After all we are all human.
But these behavioral biases, or cognitive biases, can cause serious harm to our portfolios. They cause us to differ from what we should do based upon rational systematic thinking. The best investors (or traders) in the world recognize these biases and build in safeguards to help them avoid them. The below video details the top behavioral biases, what they are, how to spot them, and how to avoid them!
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Here are some behavioral biases:
- Anchoring Bias
- What is it? Relying overly on an existing piece of information (for example your buy in price). How to beat it? Always example problems from multiple angles
- Loss Aversion Bias
- What is it? Losses hurt more emotionally than an equal gain. How to beat it? Be disicplined in your strategy
- Endowment Bias
- What is it? Irrationally placing a high value on something because you own it. How to beat it? Ask yourself, would you be in this position if you were in all cash today?
- Overconfidence Bias
- What is it? Believing you have more skill than you do. How to beat it? Introspection, checklists, extensive out of sample testing
- Confirmation Bias
- What is it? Seeking out information that confirms you existing position. How to beat it? Develop multiple sources and always play devils advocate with yourself
- Disposition Effect
- What is it? Sell winners and hold losers. How to beat it? Stick to your strategy. Have a systematic rebalance procedure.
- Mental Accounting
- What is it? Segregating parts of your portfolio and not looking at your entire portfolio (all assets: equities, bonds, crypto, etc) together. How to beat it? have a plan for your total portfolio (equities/bonds/crypto)
- Recency Bias
- What is it? Overanalyzing the recent past. How to beat it? Zoom out, look at higher trame frames. Do out of sample testing.
- What is it? Oversimplifying a complex issue (for example: saying the market went down due to a specific reason). How to beat it? Stay disciplined. Look at multiple factors from multiple angles. Always play devils advocate with yourself
- What is it? Following the crowd. How to beat it? Stay disciplined. Listen to multiple sources
- Famiiarity Bias
- What is it? Only investing in things that you know well. How to beat it? Make sure you are well diversified. It is okay to outsource to external investment managers
- Hindsight Bias
- What is it? Thinking something is easy because it was easy to spot in hindsight. How to beat it? Test your strategy out of sample! Be objective