Loss aversion, confirmation bias and overconfidence

In simple terms

Human minds use shortcuts that work well in daily life but can mislead in markets. Researchers in behavioural finance have documented many of them. Three come up again and again in investment decisions:

• Loss aversion: losses hurt more than equal gains please.
• Confirmation bias: we look for evidence that we are right.
• Overconfidence: we think we know more, and can do more, than we can.

Loss aversion

Studies have repeatedly found that people feel a loss more strongly than a gain of the same size, often roughly twice as strongly. Many people turn down a fair coin toss that wins ₹1,200 or loses ₹1,000, even though, on average, it pays.

In investing, loss aversion shows up as the disposition effect: selling winners too early, to lock in the pleasure of a gain, and holding losers too long, to avoid the pain of admitting a loss.

A related trap is getting even-itis: holding a share until it returns to the purchase price. The market does not know or care what you paid.

Confirmation bias

Once we form a view, we tend to notice information that supports it and to explain away information that does not. An investor who likes a company reads its good news carefully and skims its warnings. Online, algorithms and like-minded groups make this worse by showing us more of what we already agree with.

Defences:

• Write down your reasons for a holding, and what would prove you wrong, before you buy.
• Seek out the opposing case deliberately: read the most critical analysis you can find.
• Review against your written reasons, not against your feelings about the share.

Overconfidence

Most people rate themselves above average at driving, and many investors rate themselves above average at picking shares, which cannot be true of everyone. Overconfidence leads to:

• Trading too often, because each idea feels like a sure thing.
• Concentrating in a few holdings, as the diversification lesson warns.
• Underestimating risk, by assuming one's own analysis is more accurate than it is.

Studies of individual investors' trading records have generally found that those who trade most tend to earn less after costs.

A string of early wins makes overconfidence worse. Rising markets make most investors look skilful, as the decisions and outcomes lesson discusses.

Why knowing is not enough

Biases operate quickly and automatically. Reading about them helps you recognise them afterwards, but in the moment they feel like good judgement. Research suggests experts are not immune. What helps more is changing the situation, not relying on willpower:

• Rules made in advance, such as an investment policy statement.
• Checklists to complete before buying or selling.
• Written reasoning you can check later.
• Automatic investing, such as a SIP into a diversified fund, which reduces the number of decisions.

Why it matters

Biases cost money quietly: through trading costs, through holding failing companies too long, through missing warning signs, and through concentrated bets. Recognising them and building habits against them is one of the few investment advantages anyone can have.

Limitations

Research on biases describes tendencies across groups, not certainties about any individual. The size of effects varies between studies. Not every decision that looks like a bias is one: there can be sound reasons to sell a winner or hold a loser.

Common mistakes

• Using the purchase price as the guide to selling.
• Reading only the bullish case for shares you own.
• Mistaking a rising market for personal skill.
• Believing that knowing about biases makes you immune.

Try it yourself

1. List your holdings. For each, write whether you would buy it today at today's price, and why.
2. For your largest holding, write the three strongest arguments against owning it.
3. Count your trades over the last year and estimate their total costs.
4. Write one rule that would have prevented your worst past decision.