Recap
In the first part of this series, we looked at how certain mental shortcuts and emotional habits known as behavioral biases lead investors to make poor choices.
Some of the main biases we talked about were
Loss Aversion: People hate losing money more than they enjoy making it. The pain of losing money is almost twice the pleasure of winning the same money.
Overconfidence: Investors often believe they know more than they really do.
Herd Behavior: Following the crowd, even when it doesn’t make sense due to fear or greed.
Anchoring: Getting stuck on a certain number or past price and using it as a reference point in the future.
Confirmation Bias: Only listening to info that agrees with what you already believe.
These psychological traps lead to real financial damage—often on a massive scale.
How to Avoid Behavioral Biases
Behavioral biases can potentially be catastrophic for the average investor. It is crucial to understand how to manage behavioral biases and some potential solutions to prevent yourself from succumbing to them.
Use Simple, Written Rules
During the peak of an upswing or the bottom of a crash, it is crucial to have a set of pre-written rules to follow. These rules can help simplify the actions of investors and provide a platform for informed decision-making, thereby reducing the impact of fear or greed on investors.
Here are examples of helpful rules:
Only invest in companies you’ve researched well.
Don’t invest more than a certain percentage of your money in one stock.
If a stock falls 20% and you’ve lost confidence in it, sell.
Rebalance your portfolio every 6 or 12 months, no matter what the market is doing.
Having clear rules removes emotion from the dec
ision-making process.
Keep a Journal of Your Decisions
When you have a really successful or an unsuccessful stock, it is crucial for you to learn from the experience. After the purchase of every new company, make notes on why you bought the company, the positive factors of the company, the potential risks, and the conditions for you to sell the company.
After you end up selling the company, make notes on why you sold and whether the position worked out.
Whether the position worked out or not, identifying the reasoning behind it will allow the investor to either gain a framework for successful investments or identify mistakes that were made and that can be avoided in the future.
This builds self-awareness and helps you avoid repeating bad habits.
Challenge Your Thinking
Double-check all of your research and due diligence. Try to steelman your investment thesis to make sure that there aren’t any obvious flaws or mistakes you are making. Discuss the idea with a friend or a colleague and try to see if they can find something wrong with the idea. No investment will be perfect but you have to ensure that the downsides to the asset are substantially smaller than the positives.
How the Pros Handle Bias: Real-World Examples
Even the best investors in the world are not immune to potential bias. The bias setms from inherent human nature and hence are present in everyone. The professional investors are aware of this and use approaches to ensure that the decisions they make aren’t emotional and are fully logical.
Ray Dalio and Bridgewater Associates
Ray Dalio runs one of the largest hedge funds in the world—Bridgewater Associates.
He believes that human nature leads to bad decisions, so instead of trusting gut feelings, his team builds strict systems based on rules and data.
Bridgewater’s methods include:
Using algorithms to make decisions based on patterns and logic
Having multiple people involved in decisions so no single bias dominates
This allows him to make the best decisions for his fund in the long run and to avoid behavioral biases present in the decision-making process. Even Ray Dalio isn’t correct 100% of the time, but the decisions he makes are fully logical and reasoning-based rather than emotionally driven, which gives him a higher probability of making money compared to the average investor.
Quant Funds: No Emotions Allowed
Some hedge funds, like Renaissance Technologies, take it even further. They use quantitative models, which are computer systems that buy and sell based on numbers, not feelings.
These funds avoid behavioral mistakes by removing people from most decisions. They test strategies using years of data and don’t second-guess their systems during market panic.
What you can learn from them:
Build systems that work without constant emotional input
Make rules in calm times and stick to them in chaos
Trust data over gut feelings
Why Retail Investors Struggle More
Everyday investors are more likely to make emotional decisions because they don’t have systems or teams to back them up. This makes it harder for them to control their emotions when news headlines pop up and the market moves up or down rapidly. This leads to more buying at the top or selling at the bottom, more ignoring risk factors when markets are higher and the portfolio looks good, and more desperation in holding onto bad investments for too long out of hope.
Action Steps for Everyday Investors
Every investor should take the following steps to try to break free from behavioral biases:
Write down your investment plan. Make it simple and realistic.
Review your portfolio once or twice a year and rebalance it.
Study your past decisions and what worked or didn’t.
Talk to others before making big changes.
