Biases and descriptions source: Business Insider-20 Cognitive Biases that Screw Up Your Decisions
In part three of this series, we highlight outcome bias, overconfidence bias, the placebo effect, pro-innovation bias and recency bias. Learn 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.
11. Outcome Bias
Outcome bias is our tendency to judge a decision based on the result rather than on the process.
In other words, a positive outcome does not mean that the process and decisions leading up to that outcome were smart.
Financial markets and investing are the perfect breeding ground for outcome bias. Results are obvious and easy to obtain. But judging process and decision quality tend to be more challenging. This leads us to rely heavily on the former and focus primarily on results.
Outcome bias is dangerous as it may contribute to overconfidence and possible reckless behaviour in future decisions.
What can you do to guard against outcome bias?
Like any other bias, there are things you can do to help mitigate outcome bias. Our brain has a natural tendency to attribute outcomes to success and failure.
However, outcomes do not always determine if you did the right thing. In such cases, try asking yourself a few questions:
What caused the outcome?
Could I have followed a better process to make the decision?
Was the decision obvious before knowing the outcome?
12. Overconfidence Bias
Overconfidence bias is a tendency to hold a false and misleading assessment of our skills, intellect or talent. In short, it’s an egotistical belief that we are better than we actually are. It can be a dangerous bias and is very prolific in behavioural finance and capital markets.
Many investors tend to overestimate their analytical skills and misinterpret the accuracy of their information. This is particularly true in the internet age, where access to so much information can lead to the illusion of knowledge and control.
Overconfidence may lead individuals to take greater risks, under-diversify portfolios and trade too frequently.
Ray Dalio, the founder of one of the world’s largest hedge funds, Bridgewater & Associates, has commented many times that being overconfident can lead to disastrous results. Dalio states that he makes it a point to stay keenly aware of the possibility of his assessments being incorrect. “I knew that no matter how confident I was in making any single bet, that I could still be wrong.” With that mindset, he always strives to consider worst-case scenarios and take appropriate steps to minimize his risk of loss.
Dalio’s statement is a powerful one coming from someone who, by all accounts, is one of the people who might be well-justified in considering themselves an expert at investing.
What can you do to guard against overconfidence bias?
Here are five things you can try:
Take a more objective look at past successes. How much was due to your abilities? How much was due to external circumstances? How much was luck?
Ensure your long-term plan can handle the unexpected – like a sudden health event, longer-than-predicted retirement, or market shift.
Consider the real source of your gut feelings. Does data or external research back up your opinion?
Take a good look at the fees and tax consequences of your investment activity. How much time and money do you spend actively trading? Do the gains outweigh those costs consistently?
Look for help. Seek out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise.
13. Placebo Effect
The placebo effect is both fascinating and real, with compelling evidence of its impact in both the medical and marketing fields. But how does it relate to investing?
In the investment industry, it seems irrefutable that there is a preference for action over inaction. Amidst the constant news flow, erratic price fluctuations and increasing uncertainty, the urge to do something can be irresistible. What if I miss out? What if things go wrong and I have done nothing? How can I just sit here when all of this is happening?
The stress and anxiety created by such an environment mean that actions of questionable validity (on average) can prove a powerful short-term remedy. Making changes based on what is happening now will likely feel better for a time. The problem is they will often come at a long-term cost.
Here are some examples of the kind of investment activities that might be captured by the above definition:
Market timing – trying to sell at the top and buy at the bottom.
Trading on macro-economic news.
Performance chasing in active mutual funds.
What can you do to guard against the placebo effect?
Make sure you are investing for your long-term goals based on your:
Ask yourself, are you investing your money the way you want to? Or are your investment decisions being driven by what will make you feel better in the moment?
14. Pro-innovation Bias
The pro-innovation bias is excessive optimism about innovative or new technology and its effectiveness.
When Google Glass was announced in 2014, people were ecstatic about the potential it held. However, the program may have been too far ahead of its time. People who bought the Google Glass experienced a limited version that fell far short of its expectations.
What this teaches us is that not every technology is going to be the next big thing on its first go-around. Not every company is going to make it through the initial hype phase. Choosing where and when to invest will be extremely important.
What can you do to guard against pro-innovation bias?
Be aware of the risks.
The way we comprehend and describe risk has a strong influence on the way risk is analyzed, which in turn has implications for risk management and decision making.
Exploring risk further can move our infatuation with innovation into a more rational direction.
Being aware of the pro-innovation bias should allow us to become more skeptical about fuzzy notions of innovation and to objectively assess the possible gains in relation to the risk involved.
15. Recency Bias
Recency bias is the tendency to give more weight to the latest information received and less weight to older data.
Sometimes a recency-driven approach to decision-making is believed to be warranted by the circumstances. How often have you heard investment professionals declare, “this time it’s different.” Recency bias, similar to anchoring, comes down to letting our decisions be biased by the order in which information is received.
Investors who fall prey to recency bias tend to extrapolate the current trend and think that the market will always look the way that it does today. This can lead to unwise decisions such as overweighting recent winners rather than rebalancing a portfolio that has become dangerously under-diversified.
Chasing performance is just a sign of recency bias. Following the herd rarely pays off and is often the best way to risk buying at the top.
What can you do to guard against recency bias?
Gathering as much relevant information as you can before making a decision is an obvious step towards avoiding all the selective perception biases, including availability, anchoring and recency.
Similarly, your advisor can help you take advantage of resources to encourage knowledgeable and wise decisions.
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?
Contact us to get started.
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