Everybody has biases. We make judgments about people, opportunities, Washington policies and, of course, the markets. When we analyze our world without knowing about these biases, we put our observations through a number of filters manufactured by our experiences, and I’m not just talking about stock screeners.

I’m talking about the filters we put our decisions through that sometimes make them biased.

It’s impossible to be unbiased in our decision-making. However, we can mitigate those biases by identifying and creating trading and investing rules - but only if we know what to look for. Fortunately, investing biases fall into two categories: cognitive and emotional.

Cognitive Bias
Think of a cognitive bias as a rule of thumb that may or may not be factual. We’ve all seen movies where a thief wears a police uniform to pass through a security checkpoint. The real police officers assume that because the person is wearing a uniform like theirs, he must be a real police officer. That’s an example of a cognitive bias.

What does a fake cop have to do with your investment choices? You make the same types of assumptions that aren’t necessarily true. Here are some examples:

  • Confirmation Bias: Have you noticed that you put more weight into the opinions of those who agree with you? Investors do this too. How often have you analyzed a stock and later researched reports that supported your thesis instead of seeking out information that may poke holes in your opinion?
  • Gamblers’ Fallacy: Let’s assume that the S&P has closed to the upside five trading sessions in a row. You place a short trade on the SPDR S&P 500 (ARCA:SPY) because you believe chances are high that the market will drop on the sixth day. While it may happen, on a purely statistical basis, the past events don’t connect to future events. There may be other reasons why the sixth day will produce a down market; but by itself, the fact that the market is up five consecutive days is irrelevant.
  • Status-Quo Bias: Humans are creatures of habit. Resistance to change spills over to investment portfolios through the act of repeatedly coming back to the same stocks and ETFs instead of researching new ideas. Although investing in companies you understand is a sound investment strategy, having a short list of go-to products might limit your profit potential.
  • Negativity Bias: The bull market is alive and well, yet many investors have missed the rally because of the fear that it will reverse course. Negativity bias causes investors to put more weight on bad news than on good. Some might call this risk management, but this bias can cause the effects of risk to hold more weight than the possibility of reward.
  • Bandwagon Effect: Warren Buffett became one of the most successful investors in the world by resisting the bandwagon effect. His famous advice to be greedy when others are fearful and fearful when others are greedy is a denouncement of this bias. Going back to confirmation bias, investors feel better when they are investing along with the crowd. But as Buffett has proven, an opposite mentality, after exhaustive research, may prove more profitable.

Emotional Bias
You may notice some overlap between cognitive and emotional bias, but think about this: One reason cited by market watchers for disbelief that the current bull market is sustainable is a focus on the past. “I purchased a home in 2007 and got burned. Why would now be any different?” That’s an example of an emotional bias. Simply put, it is taking action based on feelings instead of fact. Here are a few examples:

  • Loss-Aversion Bias: Do you have a stock in your portfolio that is down so much that you can’t stomach the thought of selling? In reality, if you sold the stock, the money that is left could be reinvested into a higher quality stock. But because you don’t want to admit that the loss has gone from a computer screen to real money, you hold on in hopes that you will, one day, make it back to even.
  • Overconfidence Bias: “I have an edge that you (and others) do not.” A person with overconfidence bias believes that his/her skill as an investor is better than others' skills. Take, for example, the person who works in the pharmaceutical industry. He/she may believe in having the ability to trade within that sector at a higher level than other traders. The market has made fools out of the most respected traders. It can do the same to you.
  • Endowment Bias: Similar to loss aversion bias, this is the idea that what we do own is more valuable than what we do not. Remember that losing stock? Others in its sector may show more signs of health, but the investor won’t sell because he/she still believes, as before, it’s the best in its sector.

Take Action
There is no way to eliminate bias. It’s who we are, and those biases aren’t always liabilities. In investing, taking steps to minimize those biases is how the pros make money. Some examples may include:

Use a spreadsheet to calculate the risk/reward of every trade or investment. Set your threshold and never deviate from the rule. If a stock falls more than 7 percent (or the percentage you choose), you will immediately sell.

When you put a trade on, set an upside target. Once it reaches the target, sell the position.

Bottom Line
The only way to minimize bias is to set objective trading rules and never deviate. Overriding your emotions is a difficult task and takes time to develop. Professional traders, however, have learned that it’s the only way to make money in the markets.

Related Articles
  1. Investing Basics

    Logic: The Antidote To Emotional Investing

    Playing follow-the-leader in investing can quickly become a dangerous game. Learn how to invest independently and still come out on top.
  2. Investing Basics

    4 Behavioral Biases And How To Avoid Them

    Here are four common common behavioral biases for traders and how to minimize their effects on your portoflio.
  3. Active Trading Fundamentals

    4 Biases That Can Make You A Bad Investor

    Find out how to spot these four biases, and start making more logical investing decisions.
  4. Trading Strategies

    How To Avoid Emotional Investing

    Most investors buy high and sell low, but you can avoid this trap by using some simple strategies.
  5. Savings

    5 Ways To Control Emotional Spending

    Follow these five simple steps to keep your spending under control.
  6. Mutual Funds & ETFs

    Is Biased Investing Holding You Back?

    Risk aversion seems to come to us naturally, preventing us from stepping into unfamiliar territory. But feeling comfortable isn't always the best thing for your portfolio.
  7. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  8. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  9. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Value

    Find out about the Vanguard Small-Cap Value ETF, and explore detailed analysis of its characteristics, suitability, recommendations and historical statistics.
  1. Net Line

    The amount of risk that an insurance company retains after subtracting ...
  2. Political Risk Insurance

    Coverage that provides financial protection to investors, financial ...
  3. Head-Fake Trade

    A trade where a stock or market appears to be making a move in ...
  4. Crowded Short

    A trade on the short side with an overwhelmingly large number ...
  5. Maximum Drawdown (MDD)

    The maximum loss from a peak to a trough of a portfolio, before ...
  6. Gross Exposure

    The absolute level of a fund's investments.
  1. Can the Efficient Market Hypothesis explain economic bubbles?

    The efficient market hypothesis (EMH) cannot explain economic bubbles because, strictly speaking, the EMH would argue that ... Read Full Answer >>
  2. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  3. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  4. What are common delta hedging strategies?

    The term delta refers to the change in price of an underlying stock or exchange-traded fund (ETF) as compared to the corresponding ... Read Full Answer >>
  5. How does being overweight in a particular sector increase risk to a portfolio?

    An investor who is overweight in a particular sector risks a loss in value for the portfolio if there is a downturn in that ... Read Full Answer >>
  6. What are the primary risks an investor should consider when investing in the retail ...

    The retail sector consists of companies operating in multiple industries such as specialty retail, general retail, food and ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!