Information biases can have a big impact on the performance of traders and investors. They occur when data is viewed from a distorted perspective. Given the complexity of the financial markets, many succumb to different forms of information bias. Often, without even being aware of it happening. This can lead to suboptimal decision-making, which will directly affect one’s portfolio.
Given that the internet has let people consume information at a bigger volume than ever before, being aware and mindful of information biases has never been more important.
The Common Information Biases
While there are many kinds of information biases, there are three common ones that often affect market participants.
- Recency Bias
As the name suggests, this bias is the tendency of people to put more weight on recent events. Even in daily life humans tend to base their decision-making off of what’s currently happening.
In the context of the markets, people often place too much emphasis on the most recent market trends and structures. While there’s nothing wrong with paying attention to short-term trends, it should always be put into the perspective of the bigger trend.
- Confirmation Bias
This is when people are inclined to skew information toward their desired result. People usually favor data and information that already aligns with preconceived notions or ideas. All while disregarding or putting less weight on information that says otherwise.
In the markets, it isn’t uncommon for traders and investors to look for positive information on their favorite stock or cryptocurrency. While it’s a good start to research different investments, objectivity needs to be maintained. Succumbing to confirmation bias can lead to distorted perceptions of risk to rewards, along with the probabilities of the trade.
Sometimes, this information bias can also lead to groupthink. This is where different individuals discuss only their positive views on certain investments, creating an echo chamber that only reaffirms their initial views on the market.
- Herding bias
Somewhat similar to groupthink, this information bias is due to people’s propensity to follow the herd. Whereas groupthink is when individuals reaffirm each other’s original ideas, the herding bias is when people blindly follow what others are doing.
The best example of this is when people buy stocks due to hype. Driven as well by the fear of missing out (FOMO), many buy a rising stock solely because others are doing so. Often this is also what causes bubbles to occur. When prices start to plummet, it’s usually the unknowing investor/trader who usually gets the end of the stick.
Protecting Yourself and Your Portfolio
Overcoming information biases is something every trader and investor should aim for. Since they can affect the validity of the data collected and/or the interpretation of data, information biases will affect one’s portfolio.
One key thing to remember to avoid them is to try and stay as objective as possible. The majority of biases usually stem from either letting emotions take over or failing to try and grasp the whole situation. It takes a conscious effort to do so, and sometimes information biases can get even the best of us.
This is where portfolio tracking and backtesting can help. No matter what biases affect you, keeping tabs on how your portfolio is doing will always serve as an objective reality check. On the other hand, backtesting strategies will also help you to create a better structure for your decision-making process. By doing so, there will be fewer cracks for information biases to sneak in.
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