Behavioural Finance 101: Cognitive Bias
Being aware of cognitive biases can help us make better investment decisions.
Every day, we make thousands of decisions; some put that number as high as 35,000.[1] The vast majority are routine and without especially big consequences – but then there are the ones that matter a lot more.
Choices about investments generally fall into the “important decisions” category because what we buy, when we buy, how long we hold it and when we sell can have a significant impact on long-term financial well-being.
Yet every decision, large and small, can be influenced by myriad cognitive biases. Many of these are hard-wired into our brains to help us manage all that exhausting decision making and, in some cases, make life-or-death decisions extremely quickly.
“[Cognitive biases] are an evolutionary adaptation,” explains Dr. David Lewis, PhD, chief client officer at the behavioural economics consulting firm BEworks. “Our brains have evolved to have a very fast, non-analytical way of thinking. When confronted with danger, it doesn’t make a lot of sense to sit down and analyze what to do. It usually makes more sense to just do anything rather than deliberate.”
The trouble is that mental shortcuts, known as heuristics, can lead us to make decisions that impact us in negative ways. The good news, says Lewis, is that simply being aware of the fact that cognitive biases exist can make us pause, engage in “metacognition” (thinking about thinking) and start to make better decisions.
Who wants to lose?
You’re invited to lunch with someone who can make your career – but you hesitate. What if you spill food on your lap? What if you have a coughing fit? Do the risks outweigh the benefits? Maybe it’s safer to turn the offer down.
One of the cognitive biases that can lead investors astray is loss aversion. No one wants to lose. And, in fact, people are said to feel the pain of a market loss twice as intensely as they feel the joy of a market gain.[2] However, loss aversion can lead to decisions that harm long-term investment returns.
“Investors may not take enough risk to get the level of return they require to achieve their wealth objectives in the short, intermediate or long term,” says Lewis. “They tend to focus too much on short-term factors and avoiding risk, and the result is long-term underperformance.”
Beyond keeping assets in a portfolio that’s too “safe” to achieve their goals, loss aversion can actually convince investors to take more risk to avoid loss – for example, holding onto an investment to avoid realizing a loss when they should sell it, or trying to make up for a loss by buying inappropriately risky investments.
If you don’t want loss aversion to govern your decision making, it’s worth making a clear division between the money you’re growing for the long term and the money you need to cover shorter-term spending and emergencies. A short-term loss matters a lot if you need to access your money tomorrow – but it shouldn’t be the primary reason for an investment decision in an account that’s geared towards long-term growth.
Just how sure are you?
You’re looking for a new stove, so you pick your model and then scan websites searching for the best price. You find a great deal – but you wait. Surely prices will drop further, you think. A friend who works at the store says, “Buy now – that’s as low as you’ll find it!” You ignore them, convinced you know best, and then prices go up instead of down.
Some investors can be overconfident, believing they can predict the markets better than they really can. That can lead them to try to time the market – attempting to buy at the bottom and sell at the top. They may overtrade, incurring expenses that diminish their returns and ignoring the risks associated with active trading. Overconfidence can also mean they won’t listen to anyone else’s opinion.
“People tend to overestimate their own abilities, and that leads them to refuse professional advice,” says Lewis. “That just reinforces the errors.”
One strategy to overcome the overconfidence bias is to deliberately pause before acting on the assumption that you know best. Take the time to think through the repercussions of what you’re about to do – good and bad. Consider the possibility that your decision may put your long-term planning at risk – for example, delaying the date you can retire.
Finally, make a conscious effort to listen carefully to what others are saying, even if it disagrees with your view. Keep in mind, says Lewis, that research shows people who have received professional training in investment management, economics and finance tend to be more rational, less emotional decision makers – so your advisor is worth paying attention to.
Is it all about the “now”?
You get a bad cold and spend a few days in bed. It feels interminable. In fact, you can’t remember what it felt like to be healthy. All you can think about is the cold. Finally, you recover. And, suddenly, it’s hard to remember what it felt like to be sick.
Another bias comes into play when investors assume that current performance is representative of future performance. Known as the representativeness bias, it may make an investor resist buying an investment when prices are low (the best time to buy) or resist selling an investment when prices are high (the best time to sell).
“People can be fixated on current conditions, [and] as paradoxical as it seems, when you should take risk you don’t, and when you should be avoiding risk you take it,” explains Lewis.
In a world in which prices and information are constantly in flux, it’s important to try to see beyond each moment to avoid making short-sighted decisions.
To make the future more of an immediate concern, try asking yourself, “What will I be doing in 10 years with this money?” – and make your answer as concrete as possible. To avoid acting based on emotions about current conditions, confront how you’re feeling head-on, acknowledge it and then assess whether acting will help or hinder your ability to meet that 10-year goal for your money.
Everything under control?
You plant some seeds and, a week or so later, green shoots appear. But then they start to droop. You check on them many times a day. You talk to them, coaxing them to grow. You water them – maybe too much. Nothing helps. Maybe, just maybe, it’s about them, not you.
In life, there is a lot that we can’t control, and yet people quite reasonably prefer to feel in control. This can lead people to a mistaken belief that they can influence random events. For example, they may believe their lucky numbers have a better chance of winning the lottery, or that carrying an umbrella means it won’t rain. That’s the illusion of control bias at work.
A desire to control the uncontrollable can cause investors to take any action at all to regain a sense of control. It may also drive investors to keep very close tabs on their portfolios – and Lewis says there is a negative correlation between the frequency with which investors check their accounts and the overall return of the portfolio.
“The more frequently people check their accounts, the lower their returns,” he says. “Although they think that they are staying on top of things, in fact what that leads them to do is make poor decisions, and their returns suffer as a result.”
That suggests a quick fix to minimize the effects of the illusion of control bias: reduce the number of times every week (or every day) that you log in to your portfolio to check your investments. When you miss the inevitable minor ups and downs of your portfolio, you’ll be less likely to act for the sake of acting or sell when, for the best long-term results, you should hold.
We’re rational – to a point
Most of us would like to believe that on the whole we behave rationally, but it’s more accurate to say that we behave with bounded rationality. Our decisions are constrained by time, mental energy and limited willpower – and those constraints leave the door open for mental shortcuts that are vulnerable to cognitive biases.
The fact is that cognitive biases can affect decisions about everything from how we invest to what we buy, which job offer we take and even whom we choose as friends – but being informed about them is an important first step towards minimizing their impact and increasing the rational component of our decisions. It can also be very helpful to seek out a knowledgeable, objective second opinion – and, when it comes to investing, the best person to approach is your advisor.
“Investment advisors are incredibly valuable to investors and can really save them from making mistakes that have enduring consequences for their wealth, happiness, retirement and well-being.” – Dr. David Lewis, PhD, chief client officer, BEworks
10 OTHER COGNITIVE BIASES THAT MAY AFFECT DECISION MAKING
01. Anchoring bias: relying too much on the first information you get on a topic
02. Choice overload: delaying or avoiding decisions when there are too many options
03. Confirmation bias: seeking information that reinforces an existing perspective
04. Endowment effect: overvaluing something you already own
05. Fear of missing out: worrying that others are having a more rewarding experience
06. Herd behaviour: copying what others are doing
07. Optimism bias: believing bad things are less likely to happen to you than to others
08. Peak-end rule: judging an experience based on its most intense point and its end
09. Projection bias: overestimating how much others agree with you
10. Sunk cost fallacy: sticking with something because of time or money already invested
Source : https://humanhow.com/en/list-of-cognitive-biaseswith-examples
Discipline is what it takes to block out the noise, commitment is what it takes to walk the path to financial success and patience is what it takes to reach the goal.