- What cognitive biases are and how they impact your investing
- How cognitive biases can creep into your investment decisions
- How you can overcome these cognitive biases
I know it sounds silly, but it’s a serious question. Because whether you like it or not, studies show our brains are wired in such a way that most people’s stock predictions end up being worse than chance. So since your pet doesn’t have the same cognitive biases clouding its judgement, it stands to reason you could learn a thing or two about investing from your favourite furry friend.
And even though this idea might sound sacrilegious to active traders and investors, it’s not a new concept. In fact, the idea of humans competing with animals for investment results was first brought into the cultural zeitgeist by Burton Malkiel. In his 1973 book, A Random Walk Down Wall Street, Malkiel postulated, “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”
Let’s take a quick detour into the fascinating world of behavioural economics, cognitive biases, and what it all might mean for your portfolio.
What are cognitive biases and how do they impact investing?
Over the years, psychologists have discovered a wide range of mental filters that impact the way we think and act in our everyday lives. And many of these resultant beliefs are illogical, irrational and don’t conform to traditional economic theory. But if you’ve ever made an emotion-driven impulse buy, or found yourself too afraid to look at the balance in your bank account, well, you might already know what I’m talking about.
As our prehistoric brains evolved, we developed rules of thumb.
These rules streamlined our thinking and helped us survive and thrive as a species. Unfortunately, these rules don’t always serve us in today’s fast-moving financial markets. That means instead of logically analyzing every decision, we use heuristics, inferences, and other mental shortcuts to save time and mental energy. And what’s so bad about that?
Well most of the time, this works out fine. But every now and then, our intuition ends up causing us to make sub-optimal decisions. And the impacts of this can be especially insidious for investors. However, if you still aren’t convinced you fall victim to these foibles, then let’s look at some of the most common cognitive biases and how they might be undermining your investment success in financial markets.
Examples of common cognitive biases that could hinder your thinking
The disposition effect
If you’ve ever held an underwater stock hoping that it would return to your purchase price, you’ve probably experienced this mental bias. According to a 2009 paper from Princeton, the disposition effect is one of the most well documented phenomena in behavioural finance. This cognitive bias is the fact that investors are more likely to sell a stock that has gone up in value since purchase, yet are less likely to sell stocks that have gone down in value—hoping to hold on and avoid realizing a loss. The disposition effect has also been colloquially referred to as “get-evenitis.”
In 1979, Daniel Kahneman and Amos Tversky presented an idea called prospect theory. The central tenet of this theory is that people respond differently to gains and losses. In fact, research from behavioural finance thought-leader Richard Thaler has shown it takes a $100 gain to offset the emotional impact of a $50 loss. Or put another way, losses hurt about twice as much as gains feel good. Investopedia has some great examples of simple thought experiments you can do to test your own predisposition for loss aversion.
As described by psychology professor Shahram Heshmat, confirmation bias occurs when we seek out information that supports or agrees with our existing beliefs. Further, we selectively ignore information that contradicts our existing beliefs. It shouldn’t be a stretch to see how this can impact investors, particularly those making decisions about their portfolios. While you might think you’re being careful and diligent in your analysis, confirmation bias could be working against you.
I hope you’re starting to see how these cognitive biases can impact your investing and trading outcomes. While we like to believe we’re all rational actors, always doing what’s in our best interest, reality appears a little muddier. And the common mental pitfalls I’ve mentioned above are just the tip of the iceberg.
Economics professor Daniel Khaneman breaks down dozens of outcomes that human beings reach thanks to an array of cognitive biases in his Nobel Prize winning research paper. Wikipedia maintains a list of over 150 cognitive biases that are likely impacting your decision making. So by this point, you might be wondering what an investor can do when the deck is seemingly stacked against you. But even though there seems to be a new cognitive bias waiting for you around every turn, don’t lose hope just yet.
How you can overcome cognitive biases
Unfortunately, (at least as far as we know), no cure-all exists when it comes to tackling cognitive bias. But like any challenge you must overcome, being aware of the situation is the first step. To this end, there are some great books available that might be worth a read if you’re curious to learn more about this topic and how you can guard against it.
- Thinking Fast and Slow, by Daniel Kahneman, summarizes the award-winning research by Amos Tversky and Daniel Kahneman. This is a great introduction to the wide-ranging ways in which our brains can seemingly work against us. Also of interest, he provides many examples of when his own logic was interrupted by common fallacies and biases. It just goes to show overcoming our out-of-the-box wiring is a lifelong practice.
- Beyond Fear and Greed, by Hersh Shefrin, summarizes the behavioural influences that most commonly impact individual and professional investors alike. This book can help you understand how investors can be held back by their biases. It also shows that even the most sophisticated investors sometimes fall prey to these concepts.
- Nudge, by Richard Thaler and Cass Sunstein, illustrates how behavioural economics can be applied to improve decision making in all aspects of your life, including health, wealth, and happiness.
Of course, it won’t happen overnight. But by being consistently aware of your actions and paying careful attention to your decision-making processes, you may be able to start overcoming some of these cognitive biases. To this end, the reading list above could help you become more aware of these issues, although it’s likely to take a lifetime of care and attention to minimize the impacts of these sometimes nefarious influences.
So can your cat beat you?
By now, you should be starting to see why your cat (or dog) might be able to outperform your stock market results if given the chance to select investments at random. After all, they don’t have these same cognitive biases running in the background that even the most sophisticated of traders are subject to. Thus by thinking, “What would Pumpkin do?” before buying your next stock, you might be able to tilt the odds of investing success back in your favour.
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