Common Cognitive Flaws That Hurt Investment Portfolios
Everyone is susceptible to cognitive biases. The main difference between an average investor and a successful one is that the latter knows how to work with these biases, whereas the former often lets them get in the way of sound judgment. This article will go over some of these biases and show you how you can avoid them.
The impact bias - This bias corresponds to an overvaluation of anything that has just happened, whether positive or negative, without considering its fundamental importance on the final result. If you've had a bad year and are considering changing your strategy, don't be swayed by the fact that 'it's been a bad year. That doesn't necessarily mean anything. The same applies if you have a great run one month. It might be tempting to change your strategy because of it, but then again, it might not mean anything at all. In the end, investing is all about looking at the long-term period to see how accurate your strategy is and assess its value for future results.
The confirmation bias - This is another bias that corresponds to the tendency to seek special attention to information that confirms our own personal views. This type of bias can significantly damage your judgment, especially when you're trying to make an investment decision based on the information you've gathered. For instance, you might be willing to invest in a product just because the company's CEO is someone you know - or even your own relatives. This type of bias can easily lead you to lose money in the long run because it causes you to lose perspective and overweight your own observations.
The availability heuristic - This is a cognitive bias that corresponds to the tendency to assess frequencies and likelihoods based on availability. Simply put, if something comes to mind easily, we tend to overestimate how often it happens in reality. For instance, doing a quick search online for 'stock market crashes' or 'biggest frauds' will reveal many examples of both that have happened over the years.
The endowment effect - This type of bias refers to our tendency to give disproportionate importance to objects or concepts that we already own. For instance, you might look at your own investment portfolio and think that the stocks you own are better than those you're considering buying. Similarly, you might avoid selling a stock because you 'own it' and, as such, consider it one of your best investments. This kind of bias can significantly compromise the decision-making process in terms of picking stocks.
Inverting - This bias corresponds to stretching available data and putting more weight on what you're trying to prove true than what is actually true. For instance, suppose you are trying to prove that your stock market pick is going to do well, and you're looking for past examples of similar situations. You find a few instances where similar things happened, and the stock went up. Suddenly, the fact that your investment seems to fall into that pattern is enough evidence for you, and you proceed with your investment decision.
While there are many more cognitive biases that can get in the way of good financial decision-making, there is no way to permanently vanquish their impact. The point to keep in mind is that that investors need to be aware of their cognitive biases and then focus on facts and figures in their decisions. While this isn't easy, the following tips may help point you in the right direction.
Monitor your emotions - The first step in beating cognitive biases is to monitor your emotions. Most poor financial decision-making happens when you are severely time-boxed. Time-share salespeople have been aware of this for years and have taken advantage of it to force buyers to purchase properties on the spot by promising time-limited offers. When your brain is forced to make a quick decision, it is far more likely to fall prey to cognitive biases. If you're feeling stressed because you have to make a quick decision, pay special attention to your decision-making process.
Take a time-out - This is the most basic thing you can do. If you feel like your emotions are getting in the way, take a break for a day, a week, or even a month. If you feel like you can't completely stop, then try cutting down on how often and how much you trade.
Hire help - There are various investment advisors and money managers that specialize in certain areas or types of assets. If you are feeling overwhelmed, you can try asking one of them for help.
Cognitive biases are part and parcel of the human condition but can easily send you down the wrong pathway. When you're making financial decisions, you should be relying on your rational mind rather than your emotional mind. While you will never be able to completely control your cognitive biases, taking the time to do your homework and validate your strategy with a trusted advisor will greatly improve your chances for success.