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Introduction

People often rely on intuition to make decisions, which can lead to irrational judgements. However, these decisions or judgments based on intuition are frequently wrong in modern society due to cognitive biases.

Thinking is a time-, energy- and mentally-intensive activity. In primitive times, humans needed to respond quicly to threats (like wild animal attacks) and conserve energy. As a result, the brain evolved to favor intuitive judgements. However, in today's complex world, such snap judgements often lead to flawed conclusions because they bypass careful and logical reasoning.

In the stock market, it's commonly said, "Avoid retail investor mentality." But what does that means? I believe, for most retail investors, the most important reason for failure of investment is their cognitive biases. If we don't overcome these biases, consistent profitability will remain out of reach.

This article aims to summarize cognitive biases closely tied to investing, helping you identify and overcome "retail investor mentality".

For each cognitive bias, the article will cover:

• Its explanation of the bias.
• Examples for real-life.
• Examples about the stock market.
• The reasons behind the bias.
• How to overcome it.
• Advice for investment.

1. Fundamental Attribution Error

Explanation: When explaining other's behaviors, we tend to overemphasize personal traits while underestimating external factors. Conversely, when explaining our own behaviors, we tend to attribute failure to external circumstances rather than personal traits.

Examples for real-life:

• Tom is late because he's lazy; I'm late because today is raining.
• Tom's code has bugs because he lacks skill. My code has bugs because my boss rushed me.

Examples about the stock market:

• “This company's stock is plunging because the company is bad”. However, external factors such as economic recessions, rising raw materials costs, or geopolitical tensions might be the real cause.
• “Stock market bubbles or overvaluations happen because of greed and irrationality”. Yet external factors like low interest rates, government policies, or media hype are often overlooked.
• “The underperformance of a main company signals trouble for the entire industry”. But one company's struggles may not reflect the broader sector's health.

Why does the fundamental attribution error occur?

• People tend to focus on what is visible while ignoring hidden environment factors.
• When analyzing others, personality are immediately noticeable, while external circumstances are less apparent.
• When reflecting on ourselves, we are aware of the external circumstances we've experienced, so we attribute our actions to those factors while downplaying personal traits.

How to avoid the fundamental attribution error:

• Before drawing conclusions, consider the hidden enviornmental factors.
• Aim to gather as much context as possible to understand the full picture.
• When analyzing others, try to put yourself in their shoes and account for external influences. Similarly, when reflecting on yourself, adopt an outsider's perspective and evaluate the hidden internal factors.

Advice for investment:

• Before buying a stock, gather as much information as possible. Don't make a decision by feeling.

2. Self-serving Bias

Explanation: Self-serving bias occurs when people attribute successes to personal traits (internal factors) while blaming failures on external circumstance. This bias would make one overestimate their ability and ignore their failures.

Examples for real-life:

• “The project succeeded because of my leadership; the project failed because my team didn’t cooperate.”
• “During an exam, there were two difficult multiple-choice questions that I answered by guessing. One of my answers was correct, and the other was wrong. However, after the exam, I reviewed only the wrong answer and ignored the correct one.”

Examples about the stock market:

• "I made a profit because my investment strategy is excellent; I incurred a loss because of the unpredictable market volatility."
• "I picked a winning stock because of my analysis skills.” Yet, “I picked a losing stock because the news gave misleading information and because of bad luck", which may lead us to ignore the need to reanalyze our losing stocks.

Why does the self-serving bias occur?

• It helps maintain self-esteem and confidence, which are vital for psychological well-being. However, excessive confidence is arrogance.

How to avoid the self-serving bias?

• Acknowledge personal responsibility for failures as well as successes. Reflect honestly on your contributions to both outcomes.
• When analyzing successes or failures, ask what factors were within and outside of your control.
• Actively seek feedback from others, as they might have a more neutral perspective on your actions.
• Analyze ourself from the thrid person's perspective and cultivate self-awareness and humility, recognizing the role of external factors in both good and bad outcomes.

Advice for investment:

• When you make a profit, figure out the reason why the stock went up and check if the reason is same as what your thought, because you might have gained the profit just by luck.
• Compared to winning stocks, losing stocks are more valuable to review beacuse they can teach you why you lost money on them.

3. Bandwagon Effect

Explaination: The Bandwagon Effect occurs when people adopt a belief, behavior, or trend because “everyone else is doing it.” It highlights the tendency to conform to the majority, often without critically evaluating the situation or evidence.

Examples for real-life:

• Buying a smartphone because "everyone else has one," without evaluating if it truly meets your needs.
• Choosing a restaurant because it’s crowded, assuming it must be better than less crowded ones.
• Joining a political movement without understanding the policies, simply because it’s gaining popularity.

Examples about the stock market:

• “Everyone is buying this stock, so I should buy it too.” This may lead to participation in speculative bubbles.
• “This sector is trending—everyone is talking about renewable energy. I’ll invest heavily there,” without analyzing fundamentals.

Why does the bandwagon effect occur?

• Social proof: People look to others’ actions as a guide, assuming the majority must be correct.
• Fear of missing out (FOMO): We worry that if we don’t join the trend, we’ll lose out on opportunities.
• Herd mentality: Following the crowd feels psychologically safer than standing out and taking a different path.
• Cognitive shortcuts: It’s easier to follow others than to analyze the situation independently.

How to avoid the bandwagon effect:

• Pause and reflect: Before adopting a trend or belief, ask yourself if it aligns with your own reasoning and evidence.
• Recognize herd mentality: Be aware of situations where social pressure may influence your choices, and consciously evaluate if you’re acting independently.

Advice for investment:

• Avoid buying stocks simply because they’re trending or popular. Instead, analyze the company’s fundamentals, market conditions, and long-term potential.
• Be cautious during bubbles and hype cycles. Remember that following the crowd can lead to poor decisions when the trend reverses.

4. Halo Effect

Explanation: The Halo Effect occurs when our overall impression of a person, company, or product (often based on a single positive trait or characteristic) influences our judgment of their other qualities. This bias can lead to overestimating someone's abilities or overlooking flaws based on one favorable impression.

Examples for real-life:

• A charismatic, confident leader is assumed to also be highly competent, even if there’s no evidence of their skills.
• A person who is physically attractive might be perceived as kind, intelligent, or trustworthy simply because of their appearance.
• A well-known university graduate is automatically thought to be more capable than someone from a lesser-known school, regardless of actual performance.

Examples about the stock market:

• A well-known company with a highly admired CEO (e.g., Elon Musk or Warren Buffett) might have its stock overvalued because people assume the entire company will always perform exceptionally well.
• A company with a popular product (e.g., a best-selling phone or innovative gadget) might have its other unrelated products viewed as high quality—even if they’re mediocre.
• If a company is highly praised in the media for innovation, people may overlook financial weaknesses, assuming it will succeed in all aspects.

Why does the Halo Effect occur?：

• Cognitive simplification: Our brain prefers to simplify decisions by using one positive trait to evaluate the whole, avoiding deeper analysis.
• Confirmation bias: When we like one thing about someone or something, we tend to seek information that reinforces our positive impression while ignoring contradictory evidence.

How to avoid the Halo Effect:

• Separate traits: Evaluate each trait or characteristic individually. Just because someone is good in one area doesn’t mean they excel in all areas.
• Use data and facts: Rely on objective evidence and avoid letting emotions or first impressions dominate your analysis.

Advice for investment:

• Don’t buy stocks based solely on admiration for a company, CEO, or product. Always analyze financial reports, market trends, and industry conditions.
• Be cautious of overhyped companies and critically assess whether their overall performance supports the glowing reputation they might have.

5. Moral Luck

Explanation: Moral luck occurs when people judge someone's actions based on outcomes beyond their control, rather than solely on the individual's intent or effort. This bias means we often attribute moral praise or blame based on results, even though these results are influenced by chance.

Examples for real-life:

• A drunk driver who gets home safely might be judged less harshly than one who causes an accident, even though both engaged in the same reckless behavior.
• A project manager who takes a risky decision and succeeds is seen as a genius, while a similarly risky decision that fails is criticized as reckless or incompetent.

Examples for the stock market:

• An investor who buys into a booming stock early and succeeds is seen as visionary, while another who buys into a similar stock that later crashes is blamed for being naive or careless.

Why does moral luck occur?:

• Simplified reasoning: Judging based on outcomes is easier than analyzing the full complexity of decision-making, including factors beyond one's control.

How to avoid moral luck:

• Focus on intent and decision-making process: Evaluate whether the individual acted reasonably given the information and resources available at the time.
• Acknowledge external factors: Be aware of the role that luck or circumstances play in influencing outcomes.
• Avoid outcome bias: Train yourself to assess actions independently of results by considering how similar actions might have turned out differently under other conditions.

Advice for investment::

• Focus on process, not just results: Instead of evaluating your decisions solely by whether they made or lost money, assess whether your strategy was based on sound reasoning, research, and risk management.
• Recognize the role of luck: Understand that even well-thought-out trades or investments can fail due to unpredictable factors, such as economic shifts, geopolitical events, or sudden news.
• If a trade succeeds, don’t assume you’ll always replicate that success. If a trade fails, don’t blame yourself entirely—reflect on both your decision-making process and external influences.
• Avoid chasing past success: Be cautious about imitating others’ successful trades, as their outcomes may have been influenced by circumstances or timing that cannot be repeated.
• Plan for probabilities: In speculative trades, acknowledge that uncertainty is part of the game. Set stop-losses, diversify your portfolio, and don’t bet more than you can afford to lose.

6. False Consensus Effect

Explanation: The False Consensus Effect occurs when people overestimate how much others share their opinions, beliefs, values, or behaviors. In other words, we tend to assume that our thoughts and actions are more common or universal than they actually are.

Examples for real-life:

• After watching a controversial movie, you assume most people agree with your opinion that the movie was brilliant. In reality, opinions might be evenly split, or the majority might disagree.
• You believe that working late is the best way to succeed, so you think your coworkers agree, even though some may prioritize work-life balance.

Examples about the stock market:

• “Everyone must think this stock is undervalued, so it's bound to rise soon.” However, others might see risks or have different analyses.
• “The stock dropped because of bad quarterly results, so everyone will sell, and I should short it.” But institutional investors might see this as a temporary issue and start buying at the lower price.
• “I’m buying this small-cap stock because it has a unique product, and everyone else will see its value soon.” The broader market may not pay attention to such speculative plays for a long time.

Why does the False Consensus Effect occur?

• Limited perspective: We often surround ourselves with like-minded individuals or consume information that reinforces our own views, leading to a distorted sense of consensus.
• Ego protection: Believing that others share our opinions validates our beliefs and boosts confidence.
• Availability bias: Our own opinions and experiences are the most readily available to us, making them seem more prevalent.

How to avoid the False Consensus Effect:

• Recognize the diversity of perspectives. Actively seek opinions and feedback from individuals with different viewpoints.
• Avoid projecting your preferences or beliefs onto others. Gather data or evidence to confirm whether your assumptions about others are valid.
• Be mindful of echo chambers (e.g., social media or friend groups) that reinforce your existing beliefs.

Advice for investment:

• Don’t assume that the market will behave the way you expect it to. Many factors influence market trends, and others may see things differently.
• Don’t assume a single idea will resonate with the majority. Hedge your positions by spreading your bets across different stocks or sectors.
• Don’t rely on herd mentality: Just because a stock is trending or hyped in forums doesn’t mean it’s a guaranteed win. Validate your speculative ideas with research, news, and objective data.

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References

• List of cognitive biases(Wiki): https://en.wikipedia.org/wiki/List_of_cognitive_biases