10 Cognitive Biases To Be Aware Of In Investment

I find it useful to read a summary of psychological biases often, and to keep reminding yourself of them. Even if you are aware of your own biases, it doesn't mean that you are unaffected by them. It requires constant discipline and self-criticism to recognise when one or more biases is affecting your decision making, at any time in life.

In this short post, I will go through 10 common psychological biases and try to apply them to the process of stock picking and investment. I have certainly been a puppet to my biases in the past, and will no doubt continue to in the future, but my mission is to educate myself and work on my process enough that I see improvement in my decision making. Without further ado, let's get started.

Overconfidence Bias

Overconfidence occurs when a person's confidence in his/her judgments is greater than the objective accuracy in those judgments. It can often come from a false sense of skill, talent or self belief. It has been defined in three distinct ways:

1. overestimation of one's actual performance
2. overplacement of one's performance relative to others
3. overprecision in expressing unwarranted certainty in the accuracy of one's beliefs

A common example of overplacement is a "better-than-average" effect of drivers. If an individual is asked to assess their own skill at driving compared to the rest of the group, they are likely to rate themself as an above-average driver. The majority of the group is likely to rate themselves as above average, which is clearly not possible.

Overconfidence is a particularly dangerous bias and is also prolific in the industry of finance - with common manifestations including the illusion of control, timing optimism, and the desirability effect ("I want X to happen so X will happen"). Considering that the average investor will perform quite badly compared to benchmarks (see below chart), it is highly important to be aware of this bias and not have too much confidence in your ability to "beat" the market, or especially to "time" the market - especially before you have demonstrated any above-average abilities but also even if you have demonstrated that (dumb luck is a powerful factor in investment).

In general, it backs up the idea that the average investor should simply stick to basic, low-cost index funds instead of stock picking, to not try to time the market and, especially, to avoid leverage and trading on margin.

Tips to lessen the impact of overconfidence bias on your investment performance include:

• Being objective about your performance so far, and including the impact of luck on that performance. Use a proper statistical analysis to judge your abilities so far.
• Before making any decision, ensure to look at all the facts involved in the decision, and writing them down if possible. That way, you can come back later and judge how well your decision making process worked.
• Discuss your ideas with others and ask for tough criticism. It’s much better to have criticism of ideas and to look for “why it might be wrong” than to just look at “why it might be right”.

Self Serving Bias

Self-serving bias is the propensity to attribute any positive outcome to skill and any negative outcome to luck. It is a bias that can cause us to mislead ourselves and discount the power of pure chance in our outcomes. The bias is very much linked to "outcome bias", and "hindsight bias", where we look back at decisions we made and attribute good outcomes to "good decisions" but bad outcomes to "bad luck". This is clearly not a healthy way to self-reflect and will not do us any favours in improving our future outcomes and our investment abilities.

Tips to lessen the impact of self-serving bias include:

• Keeping a journal of your decisions and your rationale behind them.
• Go back through the journal on a regular basis and be critical of yourself – what was good and bad about your process.

Confirmation Bias

Confirmation bias is a very important one in investing and is the idea that people will only seek out information that confirms pre-existing ideas and ignore information to the contrary. Clearly, this bias is at the forefront these days with it having such a huge effect in the echo chambers of social media and the phenomenon of “fake news”. It is also highly prominent in investing and can have catastrophic impacts on your returns.

Tips to lessen the impact of confirmation bias include:

• When going through your rationale for a decision, look at the information sources you’re used: were they mostly sharing the same arguments that you already thought, or did they contradict what you thought?
• Actively look for information that contradicts your assumptions. Example: “Company X will remain the top player in the industry” – look for reasons why that might not be the case.
• Look at cold hard facts and not just judgments or predictions of the future. Put the facts on the table and then make some judgments. Do you still have the same notions as before this activity?
• Discuss your ideas with others and ask for tough criticism. It’s much better to have criticism of ideas and to look for “why it might be wrong” than to just look at “why it might be right”.

Hindsight Bias

“I knew it all along, I should have sold that stock when it was at it’s all time high!”

“I knew markets would crash, I almost sold last month, next time I will sell!”

“I knew I should’ve bought that stock, it was obviously going to skyrocket!”

Hindsight is 20/20, as they say, and hindsight bias sure is a powerful force. This bias is defined as a psychological phenomenon that allows people to convince themselves after an event that they had accurately predicted it before it happened. This can lead people to conclude that they can accurately predict other events.

Tips to lessen the impact of hindsight bias include:

• Keeping a journal of your decisions and your rationale behind them.
• Look back through your decision making processes, and at reasons you thought X event might or might not happen. Do you still agree with those possible reasons, and the likelihood you ascribed to them?
• Maintain a portfolio with a particular strategy, tuned to your preferences and skillset. Create your “circle of competence”. Great ideas will come and go outside your circle of competence, but you can ignore them. Wait for a great idea inside your circle of competence, and then swing for the fences.

Framing Bias

Framing affects how we make decisions, by how information is presented to us, or “framed”, rather than simply based on the facts. Information that is presented in a certain way may cause somebody to come to a particular conclusion, and the same information presented different may cause a completely different conclusion. Investors may pick investments different, depending on how that particular opportunity is presented to them.

Let’s take an example from Schwab: Is the “Framing Effect” Influencing Your Investment Decisions?

To understand the framing effect, consider these two scenarios:

One of your investments, XYZ, increases in value by $50 over the course of the year, but loses $20 of that gain due to some year-end market volatility.

One of your investments, XYZ, increases in value by $50 over the course of the year. The markets hit a rough patch near the end of the year, but you’re able to hold on to $30 of your gain.

The outcomes are the same, yet people are more likely to prefer scenario B because it is presented as a gain instead of a loss.

Tips to lessen the impact of framing bias include:

• Keeping a journal of your decisions and your rationale behind them.
• Don’t focus on your gains or losses. Focus on the future prospects of what you own and whether the factors that led to your ownership still hold true in your mind.

Loss Aversion

We all have an inherent loss aversion and it has been demonstrated in a number of experiments. In fact, for individuals, the pain of losing is psychologically around twice as powerful as the pleasure of gaining. The loss felt from money, or any other valuable object, can feel worse than gaining that same thing.

A chart of perceived value (Y-axis) vs a financial gain or loss (X-axis).

Loss aversion is important in investment as, for one thing, losses are inevitable. There is always a risk of loss in any investment, and it’s important to recognize your own aversion to loss and not allow it to prevent you from taking positive expected outcome investment opportunities.

Tips to lessen the impact of loss aversion bias include:

• Try not to treat your investment portfolio as “money” but rather as a collection of owned businesses. Auction market prices for those companies can go up and down in a heartbeat, but intrinsic value does not.
• Regularly assess your portfolio, ignoring any positive/negative returns on your positions, and determine if you believe they are good investments to make today at the current price. If not, consider dropping those positions, even if you are at a loss.

Herd Mentality

Ah, herd mentality, how can you be involved at all in the stock market without having been exposed to it? As we know, herd mentality is a bias that causes us to blindly copy and follow what others are doing (especially if they're famous or have a good track record in the past), without a good justifiable reason. Acting out of herd mentality is an emotional process, not based on any rational independent analysis. Examples are easy to find in the stock market and beyond - with speculation pushing some stock prices or cryptocurrency prices up to nosebleed levels, and those doing the buying not actually performing any analysis or valuation process whatsoever.

Tips to lessen the impact of herd mentality bias include:

• Before making any decision, determine if your judgment is coming from an individual analysis of information or simply from "following the herd".

Narrative Fallacy

We like stories. We find them easier to relate to, and they allow us to make sense of events and occurences. Stories have emotional content which appeals to our subconscious or reflexive reasoning and they are easier for us to remember.

The narrative fallacy leads us to see events as stories, with logical chains of cause and effect. Stories help us make sense of the world. However, if we’re not aware of the narrative fallacy it can lead us to believe we understand the world more than we really do. (Avoiding Falling Victim to The Narrative Fallacy)

The narrative fallacy can cause investors to “fall in love” with a company based on its story, rather than its true business opportunity.

Tips to lessen the impact of the narrative fallacy include:

• Any time you decide to buy or sell equity in a business, be critical of yourself and determine if you are making the decision due to the business “story” or the cold hard facts.
• Ensure to look at the other side of the narrative, and determine why your narrative might be wrong. Discuss with others and ask for criticism of your narrative.

Anchoring Bias

Anchoring occurs when an individual depends too heavily on an initial piece of information offered (the “anchor”) to make subsequent judgments during decision making. The anchor can be used as a gauge on which to judge outcomes from that point. An example of a strong anchor in investment is the price you paid to buy (or sell) a particular stock. That price is staring you in the face every time you open up your portfolio. It becomes meaningful to you, and you base decisions on it, even though it is arbitrary. You may have decided to act at that particular price point, but you should always look at the facts and make a judgment based on the price available on the market, not at an arbitrary price from a trade you made in the past.

Tversky and Kahneman found that even arbitrary numbers could lead participants to make incorrect estimates.2

"People make estimates by starting from an initial value that is adjusted to yield the final answer" – Kahnemann and Tversky

In one example, participants spun a wheel to select a number between 0 and 100. The volunteers were then asked to adjust that number up or down to indicate how many African countries were in the U.N. Those who spun a high number gave higher estimates while those who spun a low number gave lower estimates.

Tips to lessen the impact of anchoring bias include:

• Give some thought to the impact of anchoring bias on your choices. Are you analyzing all possible information, or are you basing your judgment on an existing anchor point?
• Once you’ve made a particular trade, for whatever reasons you had, try to ignore the price in that transaction. Instead, focus on what’s available in the market today and what the intrinsic value of the business is.

Representativeness Heuristic

This bias occurs when the similarity of objects or events confuses people's thinking regarding the probability of an outcome. People frequently make the mistake of believing that two similar things or events are more closely correlated than they actually are, and it appeals to our “pattern seeking” brains.

An example of this bias in investment is when investors assume that good companies make good investments. A company may be excellent at their own business activities, but a poor judge of other businesses. Another example is in forecasting future results based on historical performance. If a company has seen high growth in the last decade, it doesn’t necessarily mean that trend will continue into the future.

Tips to lessen the impact of the representativeness heuristic include:

• Learning more about statistics and logical thinking
• Discussing your ideas and judgments with others, and asking them to point out where you might be relying too much on representativeness.

Overall, having a good understanding of cognitive biases can have a great positive impact in your investments and portfolio management. It's difficult to overcome the force of psychological biases and it takes an ongoing discipline, but it can be extremely rewarding in investment and in life in general.