Investopedia has a very well-written, simple list of four behavioral biases that screw with investors on a regular basis. I’ve personally fallen prey to all of these – I still can sometimes if I don’t stay aware, this is anything but easy no matter who you are or how long you’ve been doing this.
Of the four, this one is people’s biggest downfall, in my opinion:
This is arguably the strongest trading bias. Researchers on behavioral finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year. Although financial products often include the disclaimer that “past performance is not indicative of future results,” retail traders still believe they can predict the future by studying the past.
Humans have an extraordinary talent for detecting patterns and when they find them, they believe in their validity. When they find a pattern, they act on it but often that pattern is already priced in. Even if a pattern is found, the market is far more random than most traders care to admit. The University of California study found that investors who weighted their decisions on past performance were often the poorest performing when compared to others.
How to Avoid This Bias
If you find a trend, it’s likely that the market identified and exploited it long before you. You run the risk of buying at the highs – a trade put on just in time to watch the stock retreat in value. If you want to exploit an inefficiency, take the Warren Buffett approach; buy when others are fearful and sell when they’re confident. Following the herd rarely produces large-scale gains.
Josh here – I think we’re witnessing this with some pockets of the market now, notably the “defensive” stocks which have begun to seem as though they can never go down – “In a broad rally they’ll move up with the market, in a sell-off, they’re defensive and so will hold up better!”
Yeah, okay, simple as that.