When it comes to examining how our psychology (or cognitive biases) impacts how we approach financial issues, no area has received more attention than investing. That isn’t really surprising, because results from investing lend themselves to measurement and comparison, and because, as Willie Sutton might have put it, investing is where the money is.
The clear conclusion of most studies is that we are not wired for investing. There are a number of cognitive shortcuts, or cognitive biases, that work against us. Daniel Kahneman wrote an outstanding book, Thinking Fast and Thinking Slow, about how we have two systems when it comes to thought – a “fast” system that relies on rules that we quickly apply, often automatically. The second, slower system, involves more deliberate thought which can be far superior when trying to solve complex problems, but wasn’t much good for the neolithic hunter trying to escape a predator.
While the fast system can be very effective in certain instances, many of the shortcuts it uses aren’t counterproductive when it comes to investing. Among the most common biases in investing are confirmation bias, overconfidence bias, recency bias and hindsight bias. Here is some information on each bias:
- Confirmation bias is the tendency to seek out information that confirms what you already believe and avoid information that challenges those beliefs. Once you’ve gathered that information, confirmation bias leads you to interpret that information in a way that supports your belief. Research has shown that the more emotional an issue or the more strongly held a belief the more likely confirmation bias will come into play. Finally, some research has shown that the more intelligent you are, the more susceptible you are to confirmation bias. In investing, confirmation bias will lead you to stick with an investment or investment thesis even as evidence builds that you are incorrect.
- Recency bias is the tendency to pay more attention to recent events and ignore the past. As a result, we have a tendency to believe the future will closely resemble the present. This leads to an inertial approach to investing, making it less likely you’ll make changes to your investing approach and more likely you’ll miss turning points. A good example of this is investors who have missed out on the recent outperformance of foreign stocks, because they invested solely in domestic equities given their strong outperformance in recent years.
- Anchoring generally involves sticking with a particular, arbitrary data point that has no basis in objective analysis. The most common example of this in investing is refusing to sell losing positions until the stocks regain the price you paid for them. As the old saying goes, the market doesn’t care what you paid for a stock. Sticking with a position until it reaches your purchase price – assuming that does ultimately occur – may well mean forgoing selling at a loss and investing the proceeds in a stock that would have done even better.
- Overconfidence bias is the tendency to be more confident about your predictions and judgments than objective analysis indicates is warranted. The bias covers two general categories – excessive belief in the precision of your predictions and the degree of certainty that your belief is correct. Overconfidence might lead you to believe that Acme, Inc. is a good buy, but there is a 95% change that the price will rise 23% to hit $67 per share. Many cognitive biases are closely related and appear in concert, and when overconfidence bias is combined with confirmation bias, an investor can be led far astray.
The best way to combat cognitive biases as an investor is to clearly outline your investment beliefs as well as your investment process. Thinking through your investment approach ahead of time and consistently implementing a clearly defined process will help you avoid many of the cognitive biases that appear at those times when your response is to resort to thinking fast and reacting automatically.
Minerva Planning Group is a fee-only financial advisor firm in Atlanta (Decatur). If you are interested in learning more, schedule an introductory call here.