Being aware of the biases driving irrational investment behavior can provide you with some ammunition for maintaining discipline and avoiding costly mistakes. In my experience, recency bias and loss-aversion bias are two of the most common disruptors.
Recency bias refers to the tendency for recent events to have a stronger influence on your decisions than more distant events. It convinces us that a rising market or individual stock will continue to appreciate, or that a declining market or stock is likely to keep falling. This bias often leads us to make emotionally charged decisions that could erode our earning potential by tempting us to hold a stock for too long or pull out too soon.
Loss-aversion bias describes a situation where investors feel the pain of a loss much more strongly than they feel the enjoyment of making a profit. This behavior could cause you to hold on to a losing investment too long, with the fear of turning a paper loss into a realized loss. It could also lead to selling an investment too early to lock in a profit.
Although these behavioral biases are present in everyone, they can be overcome by understanding the risks of market volatility and having a sound financial strategy in place.
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