Cognitive Biases: awareness can help investors avoid mistakes
Cognitive Biases: awareness can help investors avoid mistakes
Investors are facing complex decisions in response to current market fluctuations. Success won’t come from knowing more – predicting the market is difficult, even for professional investors. Success will depend on how you make decisions in the face of uncertainty and emotions. Being aware of your cognitive biases is the first step to making rational decisions.
Most mistakes stem from loss aversion
When it comes to investing, our grandparents had one thing right; don’t put all your eggs in one basket. But the quip ‘a bird in the hand is worth two in the bush’ may sound wise but is not sage investment advice.
It is human nature to want to hold onto what we have. We are biased towards the status quo. And most people will go out of their way to avoid a loss. They will even run away from the potential to earn an equivalent gain.
That is loss aversion. Humans feel more hurt from losing ten dollars, for example, than they feel pleasure from getting ten dollars. Typically, the potential gain must be twice as large as the loss to overcome our perceived sense of pain and anxiety.
A preference for the status quo and a degree of risk aversion was an evolutionary advantage. A caveman only survived by not straying too far from the familiar. Today, being suspicious of investments promising improbably high returns is similarly prudent. But a considered risk assessment is not the same as the more insidious loss aversion. Overcoming loss aversion starts with framing your choices.
Cognitive biases follow the market’s fluctuations
We can be reluctant investors because investing requires actions and decisions. Add a good dose of loss aversion to this natural inertia, and we tend to be comfortable with procrastination.
One sure cure for procrastination is FOMO – the fear of missing out. As markets show a strong upward trend, for example, everyone gets over their inertia and jumps on board. There are many examples of asset price bubbles, irrational exuberance and a recent example of investors not even stopping to check simple details before jumping into the wrong technology stock.
When bull markets turn, our unconscious biases get a real workout. We can anchor, endow, shield or all three along with loss aversion, procrastination and a host of other decision shortcuts.
The advertisement offering a $100 gadget for the one-time, special price of $50 is familiar. The $100 is an anchor, it convinces us of the gadget’s inherent value and that $50 is a bargain.
Investors can do something similar. Investors anchor their assessment about future performance on their initial purchase price instead of the investment’s intrinsic value. Such investor may hold onto a losing investment believing it must return to its anchor level.
Human beings also tend to endow an object they own with a higher value than the item is worth. Adding sentimental value to a symbolic family trinket is enjoyable. Adding sentimental value to investments can lead to irrational financial decisions. We may become hoarders.
We also tend to actively seek only information that supports our views and opinions and shield ourselves from any contradictory information. This bias can lead to overconfidence because everything we hear or read seems to confirm our beliefs.
Finally, we’re still loss-averse procrastinators. No matter the weight of objective evidence, some investors will only sell at a loss if backed into a corner like needing cash. But if our emotions have driven us to exit an investment, then it can be even harder to overcome our natural cognitive biases when markets recover.
Being cautious at times of heightened uncertainty and falling markets is reasonable. But the best upside potential is after a market crisis as the bear market begins to turn fretfully. Investors will need rational decisions and clear actions to seize the opportunity.
Optimising for Emotions
Economists believe in ‘homo economicus’; the always rational investor. The rest of us are human beings with hardwired emotions that shape our decisions. Instead of fighting against your nature, make your emotions work to your financial benefit.
First, focus on the why. What goal are you striving to achieve: saving for a home, a holiday, an education, financial security or a comfortable retirement? Then reframe your choices. Instead of giving into fear by listing the perceived risks of investing, apply FOMO to your goal. What is the risk of missing your goal by doing nothing or being more risk-averse than reasonable for your circumstances? It may be well worth reaching for those two birds in the bush.
These questions can be emotionally challenging – loss aversion is about twice as strong as your desire to succeed. The value of professional advice is as a counterbalance to our natural but often irrational tendencies.
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Things you should know
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