Six cognitive biases that can cost you money
Last week, we looked at four types of “stinky thoughts,” cognitive biases that can contribute to poor investment decisions. Here are six more.
Monte Carlo error: It puts too much emphasis on the likelihood of an event happening, just because it hasn’t happened recently. Think of the past 13 years of stock market growth. Many investors started betting that stocks would crash after rising for four, five, 10 or 12 years. Yet this story is statistically meaningless. The odds of a market going up or down each year are about the same, regardless of what happened in previous years.
Overconfidence: Many people think they have such good information or research that they know what’s next. As a professional investment advisor, I occasionally feel this when a client values their “gut feeling” above any empirical data or year of study their investment advisor may offer. A recent example of overconfidence bias was those who “knew” that stock markets would immediately drop if Joe Biden won the 2020 election. Instead, the market recorded the second strongest rally in history.
Confirmation bias: It is the tendency to seek only data, examples or research that confirms what we “already know to be true”. If you were convinced that the markets would collapse if Joe Biden were elected president, you would have sought information to support this position and you would have found many reinforcements. It would be more helpful to us in such cases to seek out information that contradicts our firmly held beliefs. It can help us make more thoughtful and balanced decisions.
Loss aversion: This puts more emphasis on avoiding losses than on the possibility of gain. As a result, investors want to have their cake and eat it too, looking for an investment with high return and low or no risk. When they discover that such investments do not exist, many people do not invest at all. Others go into an investment expecting it won’t go down, then sell it at precisely the wrong time.
Illusion: It’s an attitude that “bad things only happen to other people, not to me”. A deceived investor is one who keeps an investment even when it is obvious that it will never return.
Narrow frame: It is making a quick decision without gathering or being aware of all the facts and considering the implications. Usually, the investor doesn’t find out “the rest of the story” until it’s too late and the financial damage is done.
The study of cognitive biases as they apply to investing is called behavioral finance, which explores the effects of psychology on investors and financial markets. This is quite different from financial therapy, which goes deeper to understand and resolve an individual’s personal history and the traumas that cause cognitive biases.
Making rational investment decisions not only requires the ability to process our own emotional impulses, but also the knowledge and imagination to anticipate the consequences.
During a stock market decline, those who sell focus on the anxiety relief it can bring. Those who stay or increase their investments may have the same initial impulse. Yet they ignore it by first using their left brain to access the knowledge that market cycles are normal. Then they move to the right brain to imagine the anxiety that would come from missing out on gains when the market rallies.
We all have cognitive biases that affect our financial decisions. Understanding that most of us make financial decisions that aren’t in our best interests is a good first step in learning how to make those that support our financial well-being.
Rick Kahler is president and owner of Kahler Financial of Rapid City.