Here at The Motley Fool we believe shares are a smart way to build wealth for the future.
Many Australians have agreed with this sentiment in the past year, and have joined the market for the first time in droves.
It's excellent that they have dipped their toes into what can be a daunting experience. Getting started is the hard bit.
But once they're in the market, novice investors need to be aware of deep-seated psychological biases that could wreck their decision-making. These are human urges that not even professionals can sometimes resist.
Falling prey to these unconscious habits could see you make big losses when buying and selling shares.
Here are 4 of the most common ones that shareholders fall victim to:
Dunning-Kruger effect
The Dunning-Kruger effect describes the way humans overestimate their own abilities.
A classic example is how most people think they are a good driver — even though by definition not everyone can be "good".
In the share market, this is often seen in the hubris of "I can beat the market".
The reality is that even professional fund managers find it difficult to constantly outperform indices. So how would a beginner or an amateur do better (without fluking it)?
"They try to make a lot of money quickly – that's how movies like Wall Street make investing seem," Stockspot founder Chris Brycki told Yahoo last year.
"But truthfully, it's very difficult to beat the market and consistently be a winner overall."
Escalation of commitment
This is classic behaviour from many novice investors.
A stock you own has plunged in value. Then you buy even more shares — not because you think the company has a great future, but because you want to recover your losses.
If you had x dollars to invest, why would you deliberately put it into a company that's in trouble? Wouldn't it be better to invest it in something else that you have more faith in?
There is nothing wrong with buying low, but it has to be for the right reasons.
Anchoring
Anchoring is a psychological phenomenon seen in every person on a daily basis — not just in the investing world.
It describes the way humans use the first-known data as a yardstick to compare everything else that comes after it.
A perfect example is in shopping. If you first see a particular television on sale for $2,000, then seeing it sell for $1,500 at another store will seem like a fantastic deal.
But the $2,000 anchor is a random valuation, unrelated to the worth of the actual product.
A third shop may be selling at $1,200, which is the true value of the television. But a buyer that fell victim to anchoring would have already snapped it up for $1,500.
In the share market, setting arbitrary selling or buying points is a way of setting anchor.
An Afterpay Ltd (ASX: APT) shareholder who sold for $20 last year after seeing it sink to $8 in March is an example of this. (It's now more than $110)
Stock investors must always tell themselves to ignore earlier numbers and judge each selling and buying opportunity purely on merit.
Illusion of control
Our The Motley Fool colleagues in the US describe this best:
If you've ever made money day trading and patted yourself on the back for a job well done, you're probably a victim of the illusion of control.
Related to the Dunning-Kruger effect, this is when an investor thinks their own skill led to a favourable outcome — even though it was mostly luck.
This psychological bias is often seen in punters who indulge in short-term trading.
