Stock picking is a difficult endeavor and has been even more so over the last few years as investor panic over the financial crisis and recession increased market volatility. Investors can improve their prowess in the stock market by understanding various cognitive and behavioral biases that lead investors to make poor decisions on whether to buy or sell stocks.

These biases are difficult to recognize, usually operate unconsciously and are difficult to stop even when recognized. Here are four common biases that just might hurt you as an investor.

TUTORIAL: Behavioral Finance: Introduction

Confirmation Bias
Confirmation bias refers to the tendency of individuals to give greater weight to information that confirms or reinforces an existing belief or hypothesis. Evidence that contradicts this belief is discounted and given less credence. This selectivity in weighing evidence is done unconsciously by individuals and leads to incorrect decisions in the investing world. The best method of countering this bias is to look for evidence that your thesis is wrong and challenge that belief on a regular basis.

Commitment Bias
An offshoot of confirmation bias is commitment bias, which is the tendency of individuals to increase belief in an investment thesis once that position is expressed in public. Disconfirming evidence is ignored as the investor must defend his or her statements or lose face. Are you one of those investors that spends hours making posts on investment boards supporting a stock, only to see the stock plunge 20% one morning? After that, instead of rationally examining new information on the stock, do you spend even more time coming up with some tortuous explanation for why the stock is still a buy?

On the sell side this is manifested in the "no new news" report issued after a company screws up and gets hammered by the market. In this type of report, the analyst vociferously defends his thesis and "pounds the table" on the stock. (For related reading, see 5 Mental Mistakes That Affect Stock Analysts.)

Social Proof
Social proof or informational social influence is another vicious problem in the investment world and operates when an investor is unsure what course of action to pursue on a stock and looks at the actions and behavior of others to decide what to do. Dr. Robert Cialdini has written extensively on this subject and summed up social proof as viewing "a behavior as more correct in a given situation to the degree that we see others performing it."

There are certain conditions that tend to aggravate this bias in the investment world. These include a crisis situation where an investor has little time to make a decision in an environment that is rife with so called experts. Another condition that acts as an accelerant to this bias is the extent of the similarity of the group involved in the decision. When everyone looks and acts the same, social proof is aggravated. This explains why professional investors are also impacted by this bias as anyone who has worked in the industry can attest to the similarity of the institutional investment community (usually male, Caucasian, wearing suits, attended the same top colleges and hold CFAs, etc.). These three factors seem to be a fairly accurate description of what an investor confronts in the stock market and provides the psychological explanation behind the herd mentality that is so prevalent in the market.

Information Cascades
Information cascades is related to social proof and is defined as making a decision after observing the behavior of others while ignoring internal information signals that contradict that action.

This type of behavior has been observed in many areas of finance including corporate takeovers, initial public offerings, bank runs and debt restructurings. An investor that becomes envious of others making money in an asset bubble and jumps in, while ignoring his gut instinct that says not to invest, has become a victim of this bias. (Find out the strategies corporations use to protect themselves from unwanted acquisitions. For more, see Corporate Takeover Defense: A Shareholder's Perspective.)

The Bottom Line
Investors are supposed to be rational and the stock market is supposed to be efficient but we all know what nonsense that is. An individual that understands and avoids the common behavioral issues that impact decision making will be a better investor in the long run.

Related Articles
  1. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  2. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  3. Economics

    The Truth about Productivity

    Why has labor market productivity slowed sharply around the world in recent years? One of the greatest economic mysteries out there.
  4. Term

    How Market Segments Work

    A market segment is a group of people who share similar qualities.
  5. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  6. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Economics

    The Basics Of Business Forecasting

    Whether business forecasts pertain to finances, growth, or raw materials, it’s important to remember that a forecast is little more than an informed guess.
  9. Economics

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  10. Term

    Three Ways to Profit Using Call Options

    A call option gives an investor the right, but not the obligation, to buy a stock at a specific price, known as the strike price.
  1. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  2. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  3. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  4. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  5. How can I use a regression to see the correlation between prices and interest rates?

    In statistics, regression analysis is a widely used technique to uncover relationships among variables and determine whether ... Read Full Answer >>
  6. How do I calculate a modified duration using Matlab?

    The modified duration gauges the sensitivity of the fixed income securities to changes in interest rates. To calculate the ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center