Cognitive Biases in Investing Part One

Much of traditional economic and financial theory is based on the assumption that individuals act rationally and consider all available information in the decision-making process. In reality, that is far from true.


Despite our best efforts to make disciplined decisions, we are all susceptible to our own biases, whether we realize it or not.


In this series, we will highlight some of the most common cognitive biases, how they relate to investing and what you can do to guard against them.


By understanding and guarding against the common biases, you’ll have a better chance of making optimal decisions and achieving your desired outcomes.

Biases and descriptions source: Business Insider-20 Cognitive Biases that Screw Up Your Decisions


1. Anchoring Bias


Anchoring bias is the over-reliance on the first piece of information you hear and the ability of that information to frame further thinking.


Anchors are everywhere. Anytime you are presented with a number or statistic, that is an anchor.


Anchors are especially prevalent when it comes to investing. Price targets, 52-week highs and lows, moving averages, and the price you bought at are all examples of anchors.


What can you do to guard against anchoring bias?


There’s no substitute for rigorous critical thinking and a disciplined process. Take your time and seek out the facts before making decisions.


A second opinion can also help. Your financial advisor should act as your impartial second set of eyes, helping to mitigate the anchoring bias and perhaps more.



2. Availability Bias


Availability bias describes our tendency to be over-reliant on the information that is immediately and readily available to us.


There are many facets of life where blindly accepting simple cues to make decisions is not harmful and helps speed up the decision-making process.


But when it comes to your investments and life savings, this may not always be true.


The reluctance to research when choosing investments may be due to the number of options that are available to choose from today. With thousands of potential stocks, mutual funds and exchange-traded funds (ETFs) to choose from, no individual, or advisor, can be expected to research every option.


Investors and advisors tend to consider only the stocks and funds that come to their attention or are available to them. These could be recommendations from their advisor, friends, family, or online sources.


What can you do to guard against availability bias?


Utilize an investment process dedicated to finding the best possible investments that fit your unique goals and circumstances.



3. Bandwagon Effect


The bandwagon effect describes a phenomenon in which people do something primarily because other people are doing it, regardless of their own beliefs. It is also known as “herding”.


The fear of missing out (FOMO) on a profitable investment idea or hot stock is often the driving force behind the bandwagon effect. Furthermore, the prices of assets tend to rise as more people jump on the bandwagon.


For example, during the dotcom bubble, dozens of tech start-ups emerged that had no viable business plans, no products or services ready to bring to market, and in many cases, nothing more than a name (usually something tech-sounding with “.com” or “.net” as a suffix). These companies attracted millions of investment dollars in large part due to the bandwagon effect. That didn’t end so well for most investors.


What can you do to guard against the bandwagon effect?


Set up friction points. Give yourself a chance to engage the logical side of the brain. Run the idea by your advisor before buying that stock your friend recommended. If it is a good investment, it will still be there in a couple of days.


Stay informed. No one likes being in the dark. Investors are at greater risk for herding behaviour when they are uncertain about their current situation.




4. Blind Spot Bias


Everyone has blind spots. They are called blind spots for a reason: you can’t see them! If you think you don’t suffer from any cognitive biases, you may suffer from the blind spot bias.


In the investment world, blind-spot bias can lead to lost opportunities and flaws in the decision-making process.


For example, it is not uncommon for investors to take a negative view of a company, or an entire sector in general, and stay away from putting any money to work in that area. This may lead to lost opportunities as the investor will ignore the company or sector, no matter its true potential.


What can you do to guard against the blind spot bias?


It starts by addressing the biggest blind spot of all: admitting that we have any.


Next, find someone who’s advice you can trust. We don’t like taking advice from just anyone. You need to trust and respect that person. Whoever you choose, make the commitment to pay attention to when that person provides coaching about your blind spots.


Lastly, don’t make excuses when you hear the feedback. Listen carefully and add this information to what you already know about yourself and your behaviour.



5. Choice-supportive Bias


The choice-supportive bias, also called the endowment bias, refers to our tendency to feel positive about something because we have chosen it.


Having possession of something is enough to endow it in the eyes of the possessor with an unreasonably higher value than is perceived by a non-owner.


How is this relevant to investing?


Investors have a tendency to “fall in love” with stocks they own.


There are several reasons why this happens, but the bottom line is they become attached to their stocks and hold them longer than they should.


Simply put, investors can get attached to stocks they currently own, which makes them slow to recognize when there are better stocks available.


What can you do to guard against the choice-supportive bias?


Instead of falling in love with your stocks, ask yourself:

“If I woke up today and had to invest this money in the stock market from scratch, are these the stocks I would choose? Or, are there better options out there?”


Detach yourself from the fondness you may feel towards your current portfolio and never be complacent. Regularly ask yourself if there are better investments available out there in the market.



Conclusion

Want to learn how dealing with an experienced advisor and following a disciplined investment process can help mitigate the risk of falling prey to cognitive biases and keep your investment goals on track?