In his book, Predictably Irrational: The Hidden Forces That Shape Our Decisions, author Dan Ariely writes, “Wouldn’t economics make a lot more sense if it were based on how people actually behave, instead of how they should behave?”
In the same vein, investors of all backgrounds and net worth levels generally know how they should invest but nevertheless make bad investment decisions like getting deeply involved in penny stocks, gambling on the potential of a new cryptocurrency, trying to “time the market,” or investing much too conservatively for their age, goals and risk tolerance.
Unfortunately, beginning and seasoned investors alike are prone to making their own unique, seemingly irrational investment decisions. While it may seem obvious to you that timing the market is nearly impossible to do well, others are convinced their knowledge of market indicators and ability to determine when things are headed south supersedes commonsense advice to leave their portfolios as-is.
Many of these irrational decisions can be blamed on cognitive biases, but it’s not enough to simply be aware of them; you have to actively acknowledge them and develop strategies for overcoming them before they negatively impact your returns. Not sure how or where to start? Let’s explore what cognitive biases are, followed by different techniques for eliminating them from your investment approach.
What Are Cognitive Biases?
According to Very Well Mind, a cognitive bias is a “systematic error in thinking that affects the decisions and judgments that people make.” In other words, it’s a mental mistake – oftentimes related to an unreliable memory or selective attention issues – that we (un)consciously make, which can lead to detrimental outcomes for ourselves, our mental well-being, relationships, and/or decision-making in other areas of life, such as our personal financial management and investments.
Cognitive biases arise when we misinterpret, misjudge or oversimplify information around us. This can involve processing other people’s words or actions, making assessments about larger structures such as the stock market, or feeling helpless in wake of all the bad news circulating on a daily basis. While we like to believe we’re rational beings, humans are incredibly prone to making mistakes in judgment due to cognitive biases distorting our interpretation of reality.
Cognitive Biases That Can Impact Your Investments
There are many different types of cognitive biases, but those with the greatest potential to hurt your investment portfolio and returns include:
- Confirmation Bias: favoring information that aligns with your beliefs (e.g., “6% is a good rate of return-seeking higher returns would be pointlessly risky”) and discrediting or ignoring information that goes against your beliefs (e.g., “10% returns sound too good to be true – I’m sticking to my ‘slow and steady’ approach instead”)
- Halo Effect: your personal feelings about a company influence your decision to invest in it, regardless of evidence suggesting it’d be a bad idea (e.g., people who invested in Bernie Madoff’s Ponzi scheme because he seemed like a charismatic, trustworthy guy)
- Optimism Bias: belief that you’ll be more successful and less prone to mistakes/misfortune than other people (e.g., “I can worry about saving for retirement later; I’m not ‘too late’ like those other people are”)
- Self-Serving Bias: we congratulate ourselves and take credit for positive outcomes but blame external causes for negative outcomes (e.g., “I knew Bitcoin was going to be big, which is why I invested early on” and “it’s not my fault the value of Bitcoin crashed – it will come back up when people realize how crypto is an ideal alternative to government fiated currencies”)
- Dunning-Kruger Effect: not realizing you’re as incompetent about something as you actually are (e.g., “I know how to time the market, so I’m going to base my investment decisions on my intuition.”)
How to Overcome Cognitive Biases
The first step to preventing cognitive biases from hurting your investment returns is acknowledging your bias in the first place. This is more difficult in practice than you might think, since we typically prefer to think of ourselves as intelligent, rational beings and believe “other people” are the ones with the cognitive bias problems.
Nope, sadly we all have cognitive biases, so start by identifying which ones you could be guilty of, followed by mapping out your investment strategy with a knowledgeable finance professional (or at least someone who has the expertise to determine whether an investment decision is a good idea and someone who has the courage to provide constructive criticism if they believe you may be making a mistake).
We may not be as rational as we like to believe we are, but that doesn’t mean you have to throw your hands in the air and give up trying to conquer your cognitive biases. By understanding what these biases are, how they influence investment decision-making processes and developing actionable strategies for overcoming those biases, you’ll be in a much better position than someone who turns a blind eye to their own biases and insists that they’re an objective investor.