5 Investing Mistakes You Don’t Know You’re Making, Plus Tips to Work Around Them

Jul 15, 2022

As investors, we’re often our own worst enemies.

We like to believe that we make rational decisions with our money. Unfortunately, research shows we often fall victim to common, subconscious errors in thinking known as “cognitive biases.”

I covered one of the most dangerous of these biases — loss aversion — in detail in a previous Money Talks issue. (If you missed it, be sure to catch up here.)

However, there are literally dozens of other cognitive biases that can trick us into making less-than-ideal choices with our money.

So today, I’d like to share five more common biases that often lead investors astray and how you can protect yourself from them.

(These ideas assume you’re already following good risk management strategies such as trailing stop losses and proper position sizing.)

1. Confirmation Bias

Confirmation bias is the tendency to seek out or emphasize information that confirms what we already believe while ignoring or disregarding contradictory information.

For example, an investor who is bullish on a particular stock is more likely to notice positive news headlines or research reports about that stock than negative ones.

That’s a serious risk in the era of social media and “fake news.” You can often find data to support just about any view today.

Confirmation bias can give you a false sense of security and lead you to take more risks than you otherwise would.

How to protect yourself from this bias:

  • Try to keep an open mind with new ideas and information.
  • Take the advice of billionaire investor Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s business partner, and practice seeking out and studying viewpoints that challenge your beliefs.
    As Munger famously put it, “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”
  • Share your investment ideas with unbiased friends or colleagues to see if they agree with your theses.
  • Periodically revisit the reasons you’ve made an investment to confirm they’re still valid.

2. Oversimplification Bias

This bias refers to the tendency for humans to try to break complex ideas down into clear and straightforward explanations.

While this can be a helpful strategy in many areas of life, it can be problematic when dealing with inherently complex subjects. And many aspects of investing certainly qualify.

For example, regular Money Talks readers know I love to trade options. When done correctly, options trading can be incredibly safe and profitable. But if you don’t understand how options work, you can easily blow up your account with them.

How to protect yourself from this bias:

  • Aim to stay within your “circle of competence.” Be honest with yourself about your investment experience and knowledge. If you don’t understand a particular investment or strategy, avoid it until you do.
  • Seek to increase your understanding of complex or confusing ideas if appropriate.

3. Overconfidence Bias

Overconfidence bias is the tendency to overestimate our own skills and abilities.

A classic example has to do with driving. Surveys from AAA have routinely shown that nearly 75% of Americans consider themselves better-than-average drivers. Yet by definition, many of those folks must be worse than average.

Most of us are guilty of this bias in some areas of our lives. But it’s common among investors, especially those who experience early success (like I did).

In investing, this bias can lead you to make impulsive decisions and take on more risk than you otherwise would.

How to protect yourself from this bias:

  • Review your past investment decisions and objectively assess how they worked out. Make a point to highlight examples when excessive confidence has led to poor results in the past. Research shows this simple process can be a powerful way to guard against the dangers of overconfidence.
  • Consider performing a “premortem” before you make a new investment. This process is a favorite of Nobel Prize-winning economist and behavioral psychologist Daniel Kahneman.

To conduct a premortem, you’ll first imagine it’s sometime in the future — anywhere from a few months to several years — and the investment or strategy you’re considering has performed incredibly well. From this future perspective, try to brainstorm all of the potential reasons it did so well.

You’ll then do the same exercise again, only you’ll imagine the investment or strategy performed terribly this time. Try to think of all the potential reasons for its failure.

This process can help you see potential risks (and sometimes benefits) that you may initially overlook due to overconfidence.

4. Information Bias

This bias refers to the tendency to believe that more information will always improve decision-making. Again, this is particularly common in investing due to the overwhelming volume of financial news and information available to investors 24/7.

Unfortunately, much of this content is little more than “noise” that doesn’t help you make better decisions with your money. And consuming too much of it can lead to “information overload,” indecision, and over-trading.

How to protect yourself from this bias:

  • Limit excessive consumption of financial news and media. Reading the newspaper or investment research is fine; mindlessly scrolling through financial news websites or social media can be problematic.
  • Have a plan and stick to it. Decide in advance when or why you’ll sell any position, and then have the patience to allow your thesis to play out.
  • Don’t track your portfolio more frequently than necessary. Unless you’re a short-term trader, you probably don’t need to check your portfolio every day or even every week in some cases. That is particularly true if you use TradeStops or another system to alert you when important events occur.

5. Herd Mentality Bias

Finally, the herd mentality or herd behavior bias refers to the natural tendency to “follow the crowd” when making a decision.

Like many biases, this one has a strong evolutionary component. For much of human history, our survival depended on tribal or community cooperation. So, we’re programmed to want to conform to the actions of those around us.

This instinct to “fit in” is still helpful in many areas of life. But when it comes to investing, it can get us in serious trouble.

Following the herd typically feels safer. But it can lead us to take excessive risks and make foolish decisions.

We need only look back to the recent boom and bust in speculative “investments” like meme stocks, dog-themed cryptos, and digital pictures of apes and rocks to see the consequences of this bias in action.

How to protect yourself from this bias:

  • Make a conscious effort to form your own opinion on any potential investment. You may still ultimately agree with the consensus view, but you’ll likely gain greater conviction and a better understanding of the potential risks if you’re wrong.
  • Take extra time when considering an investment in a popular stock or asset. Feeling like you need to act quickly is often a red flag that you’re under the influence of herd mentality.
  • Understand that the crowd is often wrong at extremes, but it isn’t always wrong. Blindly taking the opposite (or “contrarian”) stance can be as risky as following the herd into any investment.

The Bottom Line

Completely avoiding these hard-wired tendencies is easier said than done. Even successful professional investors aren’t immune.

But simply understanding how these biases work — and practicing a few simple strategies to protect yourself — can make a huge difference in your long-term success.

Which of these biases have you experienced as an investor? Have you struggled with any others? I’d love to hear from you at [email protected]. As always, I can’t respond to every email, but I read them all.