4 Behavioral Biases and How to Avoid Them (Investing and Trading)

Behavioral biases are irrational beliefs that lead you to make irrational decisions without even realizing it. They include overconfidence, buying and selling at the wrong moment because you don't want to feel regret, relying on insufficient information, and jumping on passing trends.

Traders and investors should recognize these biases and watch out for them to lower the risk of making illogical decisions. In this article, learn about four common biases and how to overcome them.

This post is a translation of the Binance Academy article "What Are Behavioral Biases and How Can We Avoid Them".

Introduction

If you're unaware of behavioral biases, they can lead to poorly performing trading and investment decisions. In fact, there's an entire field of study called behavioral economics that combines psychological theory with traditional financial economics. Biases are often unconscious, so you need to pay close attention to your own behavior to avoid making decisions based on them.

Human behavior and psychology have been studied extensively by Daniel Kahneman, an Israeli-American psychologist and economist, and Amos Tversky, an Israeli cognitive and mathematical psychologist. If you're interested, we recommend reading "Judgement Under Uncertainty: Heuristics and Biases".

Overconfidence

"The illusion that we understand the past fosters overconfidence in our ability to predict the future." ― Daniel Kahneman

Overconfidence bias makes traders so sure of their trading skills that they make risky market decisions or trade far too often. It can also make you overly confident in assets you've already invested heavily in, getting in the way of diversifying your portfolio.

There may be exceptions, but research from Columbia University found that active individual investors tend to earn lower returns. Consider trading less and focusing on investing instead, since investing involves more fundamental research into an asset's intrinsic value.

After doing proper research, you might also consider diversifying your trades.

Regret aversion

According to research by Jie Qin, a professor at Ritsumeikan University, published in the "Journal of Economic Theory", traders are twice as likely to close winning positions too early or close losing positions too late in order to avoid regretting their gains or losses. By nature, humans tend to want to avoid regret, even when it's illogical.

To curb the urge to avoid regret, you can stick to a specific trading or investment strategy instead of making decisions in the middle of market volatility. A simple way to do this is to decide on prices and amounts in advance and automate your trades.

One such strategy is dollar-cost averaging (DCA) (buying in regular installments), where traders invest a fixed amount at regular intervals regardless of the asset's price.

You can also use trailing stop orders. These let you place orders preset at a specific percentage. Besides automatically tracking price movements, trailing stop orders can be used to limit losses and protect profits. Ultimately, this can help you avoid missing market timing.

Relying on insufficient information

There are countless opportunities to invest in a wide range of assets on the market. However, we often don't fully consider our various options before making a trade.

There's also often a lot of market noise surrounding investment opportunities. This can lead you to make trading decisions based on inaccurate or insufficient information.

If you haven't researched something in detail, don't rush into a trade. Instead of looking for easy information, do your own research (DYOR). Carry out proper fundamental and technical analysis before trading.

It's also best not to rely on the information and opinions of the many influencers who claim you can expect great returns.

Jumping on passing trends

Another study conducted by Tulane University found that 39% of all new capital allocated to mutual funds went into the top 10% of funds that performed best over the previous year. This shows a tendency to chase trends, which can be a hasty move rather than a logical decision made after sufficient research.

Market volatility can dazzle traders with huge price surges and cause them to neglect the fundamental research behind those sharp rises. Instead of following the crowd and focusing only on tokens that are performing well, consider looking for undervalued assets.

As Warren Buffett says, "Be fearful when others are greedy, and be greedy when others are fearful."

Closing thoughts

As humans, it's natural to want to rely on instinct when making decisions. However, if you observe your own behavior and make an effort to curb behavioral biases, you'll be less likely to make poor trading decisions.