Biases and descriptions source: Business Insider-20 Cognitive Biases that Screw Up Your Decisions
In part two of this series, we highlight clustering illusion bias, confirmation bias, conservatism bias, information bias and the ostrich effect. 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.
6. Clustering Illusion Bias
The tendency to see patterns in random events is called the clustering illusion.
In other words, we try to create order from chaos. Although it may help make sense of randomness, the clustering illusion bias has drastically adverse implications for financial and investing decisions.
For example, if an investor follows a stock for four days and it goes down, up, down, up, the investor might believe there is a trend when, in fact, there is none. Same with a coin toss. If someone sees heads four times in a row, they may believe that the next one will be the same.
The clustering illusion bias can create many traps for investors. For example, the use of short-term performance may convince an investor to:
Invest in a particular asset class over another
Follow a specific investing style
Invest with a certain fund manager
Investors should not place a great deal of emphasis on short-term performance to identify trends. Doing so may subject you to cluster illusion bias. As is commonly said in the finance world: “Past performance is not indicative of future results.”
What can you do to guard against the clustering illusion bias?
Maintain a healthy dose of skepticism. Assume that there is no correlation between any two random events.
Second, make sure you use enough information in your decision-making process. The smaller the information set you use in your decision-making process, the more likely you are to fall victim to the clustering illusion. Make sure your evidence is robust. Be rigorous!
Remember, if there is a reason a stock or fund has experienced a “string of heads,” like in a coin toss, it is likely that players with far greater resources than you have already identified and exploited that pattern long before you came along.
7. Confirmation Bias
Confirmation bias is perhaps the most widely recognized cognitive bias, not only in investing but throughout our lives. It is the tendency to favour information that supports our views and discount the information that does not.
When it comes to investing, how often do we point to research articles or analyst opinions that support our decision to hold a particular investment and dismiss those that argue the opposite?
Here are a couple of common confirmation bias examples in investing:
For existing positions, investors search for confirming evidence and quickly dismiss data confronting their investment thesis.
When researching new investment ideas, investors tend to gather information in a biased way.
What can you do to guard against confirmation bias?
The first step in overcoming the confirmation bias is to have an awareness that it exists.
Once you have gathered information that supports your current opinion about a particular investment, seek alternative ideas that challenge your point of view. Try being your own “devil’s advocate” and argue the other side.
Your goal should be to understand and maybe even appreciate other points of view to clarify your thinking.
8. Conservatism Bias
Conservatism bias refers to the tendency to revise your opinion insufficiently when presented with new evidence.
In other words, it occurs when a person places more weight to their prior view and less to new information that may change that view. This works out that the first information a person comes across to inform their opinion is considered to be more important than new information. For instance, people reading an article that a car brand is likely to break down. A year or two later they read that this brand is now very reliable but still carries the opinion that they are a poor purchase.
When people emphasize original, pre-existing information over new data, it can make you slow to react to critical information.
In investing, conservatism bias can lead investors to under-react or fail to make adjustments in their portfolio in light of new information. It could be corporate events, such as earnings announcements, dividends and stock splits, or economic updates, such as GDP, unemployment numbers and stimulus packages.
What can you do to guard against conservatism bias?
React decisively to any new information and seek unbiased counsel.
When you find yourself ignoring information because it is difficult to understand, you need to either take the time to figure it out or reach out to a professional that can help explain what is happening.
Arriving at a perfectly optimal decision is tough. Don’t worry about being right today. Focus on being less wrong tomorrow.
9. Information Bias
Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue.
Investors are bombarded with useless information every day. There are entire news shows and financial columns dedicated to evaluating movements in share prices on a moment-by-moment basis. It is difficult to filter through all the “noise” and focus on relevant information.
Investors sometimes make investment decisions based on the short-term movements in the share price. It may cause investors to sell great investments too early because the share price has recently fallen. It may also lead investors to buy bad investments based on a short-term rise in the share price.
In our view, daily share price and market movements usually contain little to no information that is relevant to an investor who is concerned about the medium-term prospects for an investment and, more importantly, their long-term goals.
What can you do to guard against information bias?
In general, investors would be better served by ignoring daily share price movements. Instead, focus on the medium-term prospects for the underlying investment and the long-term goals for your investment portfolio. By ignoring daily commentary regarding share prices, investors would overcome a dangerous source of information bias in the investment decision-making process.
10. Ostrich Effect
The ostrich effect is the tendency to ignore a dangerous or risky situation. If you can’t see it, it must not exist.
When it comes to investing, the ostrich effect refers to investors’ tendency to dislike receiving negative information. For example, when we are in a market downturn, we tend to avoid negative financial information, like checking the value of our investment portfolios. While ignoring the losses does not make them go away, pretending they aren’t there may make you happier.
What can you do to guard against the ostrich effect?
Instead of avoiding the negative information, you should jump in and address it. Financial planning, budgeting and investing can be confusing, complicated and stressful. It’s often easier to do when you do it with someone else, like a financial advisor. They can hold you accountable for the changes you want to make and keep