3 Cognitive Biases that Hurts Investors

October 17, 2019 | Michael Tse


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Understanding the biases that affect investment decisions

Whether we are deciding what to eat for lunch, or how to invest our money, our decision-making can be influenced by a variety of cognitive biases. Cognitive biases refer to the ways in which our brains employ mental shortcuts to deal with our limited time, mental energy and willpower while making decisions. Instead of sitting down and analyzing each potential outcome, our brain has adapted and formed a more emotional-driven way of thinking.

In the everyday decisions that bear little consequence, this makes life easier and more efficient. For example, when at a food court with multiple options to choose from, you may automatically line up at the stall with the longest line. This is a cognitive bias of herd behavior, which entails following what others are doing without any significant analysis.

Investment decisions can also be impacted by cognitive biases, so being aware of these biases can help us make better choices. Below are a few common biases that can impact investors.

Loss Aversion Bias: Everyone wants to avoid losing capital, but some try to avoid loss at all cost. Some investors experience the pain of a market loss twice as much as the joy of a market gain. As a result, these investors do not take on enough risk to achieve their long-term return objectives.

Solution: Short-term losses only matter if you need that money tomorrow, or sometime in the near future. To avoid this bias, you should make a distinction between investments that are growing for the long term, and money that you need for everyday living. The decisions made for investments that are long-term in nature should not be impacted by short-term swings.

Representative Bias: The assumption that current performance is an indicator of future performance. Investors look favourably at investments that are currently doing well, and make the projection that the performance will continue in the future. The case is the same with investments that are doing poorly. This leads to a pattern that is the opposite of the ideal “buy low, sell high” strategy.

Solution: An honest assessment of each investment is required. Are you making this decision based on current performance, or is it driven by fundamental and economic factors? If the answer is the former, you may want to sit back and acknowledge that emotions are influencing your thinking, and potentially hindering your ability to reach your long-term goals.

“Fear of Missing Out” Bias: This is the concern that others are having a better return and more rewarding outcome with their investments. You hear this quite often at cocktail parties or gatherings, where one person shares an investment that has yielded them a great return; this may lead others to follow suit and purchase that investment out of the fear of missing out. This leads to investments that may not be the “right fit” in terms of risks, timing, or market conditions. The return on the investment may be desirable, but the volatility associated with it (which your friend likely failed to mention) may keep you up at night.

Solution: A good investment that works for your friend may or may not work for you. Before jumping knee-deep into another’s investment strategy, you should analyze and evaluate if this investment is suitable for your personal objectives. Investments are not a one-size-fits-all concept.

As investors, we like to believe that we are making our investment decisions rationally, but cognitive biases could be playing a greater role than you realize. Seeking professional investment advice is a great way to incorporate expert knowledge and objectivity into your investment strategy.