How Cognitive and Emotional Biases Affect Investing?

Introduction

Due to a host of factors, the human mind does not always think rationally. Although there is a lot of room for emotions in many human affairs, there are certain areas where rational thinking is crucially needed. For example, you can’t afford to be emotional while investing.

Our evolutionary biology is at work when we behave emotionally where the situation demands us to act rationally. The advent of markets, especially the stock market, is a very recent development when viewed in the backdrop of human evolution. In fact, if the entire human history is plotted on a scale of 24 hours, the stock markets came into being only a few seconds before midnight!

Due to the prevailing uncertainty, the two dominant emotions for the survival of our distant ancestors were greed and fear which worked very well for them. However, in today’s relatively settled and predictable environment, especially in the markets, there should be no room for greed and fear. Ideally, we should be able to think absolutely rationally while making investment choices.

Greed and fear are mainly responsible for most of the emotional biases we bring to the market. However, there are some cognitive biases, as well, which may affect our decision-making. Cognitive biases may be due to wrong application of established rules or emotional thinking.

These biases affect our choices negatively in all spheres of activity as well as in the markets. Knowing how they work and affect our thinking can be very useful in preventing faulty decision-making. A brief introduction to these biases is being given in the succeeding paras.

Confirmation Bias

This bias is due to a natural human tendency to seek or give more weightage to the information that supports an existing conclusion or a dominant view. You might find yourself more readily inclined to believe in an argument that confirms a position, may it be social, political, or financial, that you have already taken or about to take vis-a-vis a counter-argument. One manifestation of this bias, with regard to markets, is that you may have a bias towards seeking information that supports your investment decision no matter how costly or damaging it may turn out to be later.

Remedy

Don’t get emotionally involved with your investments. Try to think rationally. Be always open and neutral to new information, ideas, and fresh ways of thinking. Being wrong in investments is not bad as long as you are willing to learn and correct your mistakes, purely on the merit of the argument.

Bandwagon Effect (aka Groupthink)

You might have observed or felt that being part of a group lets you feel safer. While it was a good idea, for our ancestors, to move around in groups in African savannas, it can be detrimental in investing.

There is a usual style of decision-making that people follow. Before deciding on a buy call, they ask some people in their social circle or some so-called experts, how do you feel about it? or what do you say about it? If 7 or 8 out of 10 people say it is good, they feel inclined to buy it. This is due to the bandwagon effect.

Moreover, if you make an investment alone in a particular product and lose money, the psychological pain it will cause will be much more than if you do the same thing alongside a number of other individuals and all of you lose money. The financial effect for you is exactly the same in both situations but the emotional effect is different.

Remedy

Have a pre-defined personal process of thinking while making investment choices. There is nothing wrong with discussing various investment options with your friends and “experts”. When someone says something looks good, always ask why do you think it does? Pay real attention to what he/ she says in response and know how to process that information while making your own investment decisions.

Loss Aversion Bias/ Endowment Effect

The psychological tendency to avoid losses more than making gains is called loss aversion bias. If you lose a certain amount of money, it is likely to pinch you more than the good feeling you will have if you earn the same amount of money. Quite similar to this is the endowment effect, where people tend to value more what they own, in comparison to something that is almost identical, but they do not own it.

This results in irrational decisions in investments. For example, you have made a wrong decision in buying an investment and after some time, you have realized your mistake but you will not be able to make a selling decision easily due to loss aversion bias. Instead, you might decide to stay on with the hope to recover your loss and then sell it. This bias can also prevent you from following another important principle of investing i.e. opportunity cost.

Remedy

Try to see various options strictly on their financial merit rather than from a personal standpoint. If you have realized that a mistake has been made, it is better to correct it right away rather than hoping against the hope to recover your losses.

Sunk Cost Fallacy

In financial parlance, sunk cost means an expense that has already been incurred and cannot be recovered. Sunk cost fallacy implies that your past expenses or investment choices may bear heavily on your future decisions whereas actually, they should not. Sunk cost fallacy is also known as the Concorde fallacy as UK and Frech governments persisted with the Concorde project for many years, on the grounds that so much investment had already been made, instead of immediately cutting their losses, despite having realized that the project was not financially tenable.

Sunk cost fallacy works in tandem with loss aversion bias and the endowment effect.

Remedy

The best remedy to sunk cost fallacy is to consider all previous buying transactions as sunk costs and make the decision to sell or hold a particular position in relation to its opportunity cost. It implies that by retaining a particular position what other investment opportunities you are missing. Weight it against those and decide on merit. What has been done in the past, cannot be undone, and holding on to a loser will only exacerbate the problem.

Oversimplification Tendency

The human mind craves simplicity. It tries finding a pattern even where possibly can’t be any. It is due to the survival instinct that worked perfectly well when our environment was very uncertain and insecure thousands of years ago but not anymore.

There is nothing wrong with trying to simplify an intricate situation by carrying out extensive research and using some modern tools, however, we should be mindful that simple answers to difficult problems are often wrong. Some matters are inherently complex or uncertain and do not easily lend themselves to easy explanations.

This is as applicable to investments as it is relevant in other areas of life. Capital markets are immensely complicated and it is not possible to successfully bet on their daily, weekly, monthly, or even yearly movements. Thinking that now the prices are down, so I will buy now and these are going to go up tomorrow or in the near future when I will sell to make money is a classic example of oversimplification tendency.

Remedy

Make your decisions according to authentic data, not hearsay and rumors. Develop your expertise in a small area, become competent and then strictly stay within your circle of competence while consistently trying to expand it.

Analyzing a particular business and seeing whether it is going to make money over a considerable period is easier. Betting on the direction the market is going to take in a relatively shorter time is very difficult, almost impossible.

Another way of dealing with this tendency is that some businesses are easier to understand and have a predictable trajectory whereas others are very complex and unpredictable. Stick with the former and avoid the latter.

Hindsight Bias

Hindsight bias is an interesting trick our mind plays on us. As they say, hindsight is always 6/6. You must have observed it on the media or you may have done it yourself sometimes. People often predict the outcome of complex future events e.g. elections, who will win a particular game, the direction markets are going to take, and much more, and when it turns out as they predicted they say, “I told you so”. This is because of the hindsight bias.

Because of the hindsight bias, a particular outcome looks simple to predict after it has happened. In reality, it is not like this. Talking specifically about the markets, you cannot possibly make a pattern of how markets behaved last week or last month and extrapolate it to make a prediction about the next week or next month.

Remedy

Avoid making predictions about complex events and if you do, stop taking credit if your prediction turns out to be right. It was more of a coincidence rather than anything else. The only correct answer in such situations is, I don’t know.

Never bet on the direction of the market, especially in the short term. It should be preferable to make safe assumptions about the individual businesses with humility.

Anchoring Bias

Anchoring bias is the human tendency to get anchored to or attach more importance than it merits, to a past event or a particular piece of information or anything else and lose objectivity in the process. Shrewd salespersons use the anchoring bias all the time against unsuspecting customers. For example, a real estate sales representative can make his/ her client visit 2-3 expensive properties before taking him/ her to a relatively cheaper option. This way it becomes easier to finalize the deal if the anchor has been created successfully.

In the case of stock market, the current share price can act as a strong anchor for many people, although the share price alone doesn’t say anything about the business, unless it is related to earnings and other fundamentals of the company.

Different people may have different anchoring biases.

Remedy

Be very mindful. Learn to attach due importance to each factor in your analysis. Go systematically. Be slow and deliberate in your decisions instead of rushing through the process.

Gambler’s Fallacy

The gambler’s fallacy (aka Monte Carlo Fallacy) means to, erroneously, believe that a series of past events can have a positive or negative effect on a random future event. Stock traders often fall victim to this fallacy. Let’s say the market closed in negative for five consecutive sessions. Taking a position in the market while thinking that the market will be positive in the sixth session is due to the gambler’s fallacy. The market may or may not be positive on the sixth day but it has nothing to do with this way of thinking. You may also say that gambler’s fallacy is a form of oversimplification tendency.

Remedy

The simplest remedy is not to have a gambler’s mindset and avoid looking for quick gains. While investing, one should always think like a business owner.

Overconfidence Bias

Overconfidence bias is thinking, due to one reason or the other, that in a certain field you can do better than others. The rabbit and the tortoise story in a typical example of overconfidence bias. This happens in the market all the time. The market is going to reward or punish you on the merit of that particular decision. It doesn’t know the reason why you are overconfident.

Remedy

Always be humble and keep learning.

Risk Aversion Bias

Risk aversion bias means being overly concerned about risk. While being able to evaluate risk correctly is healthy and useful, exaggerating risk and being fearful can deprive you of so many good opportunities.

There is a common perception that stock market is very risky, hence we should not invest in it. This is due to the risk aversion bias. Stock market is not riskier than it actually is. Instead of not investing at all, a better approach would be to learn to evaluate the risk and try to mitigate it while investing.

Remedy

Learn to assess financial risk correctly and try to mitigate it as much as possible. To read more on financial risk, please click here.

Information Bias

Some people collect and hold a lot of information on a particular subject and then like to believe that they can do better in that field since they are more informed. This is called information bias.

Information bias is relevant to stock market also. Watching business TV channels a lot doesn’t make you a better investor. In fact, knowing about the minute to minute change in the share prices is counterproductive. Instead of collecting information for the sake of it, what is more important is to know which information is useful and which is unnecessary. Then being able to correctly process and analyze the available information for making correct decsions is extremely important.

Remedy

We are living in the information age. Threre is an enormous amount of information and data out there. Be very selective. Learn to distinguish information from noise and then how to use that information for making better investment choices.

Incentive Bias

Incentive bias refers to the influence that rewards and incentives can have on human behavior. You must have heard offers like, “Buy one, get one free”. Incentive bias is an effective sales strategy and it forces people to buy things they don’t need.

It works very effectively in the markets also. Any chance or expectation of quick money can jeopardize a deliberate decision-making process on part of the investor. As Warren Buffet once said, “Nothing sedates rationality more than large doses of effortless money”.

Remedy

Always think about investments according to a pre-defined process. The main question to ask yourself is whether you need something or not. The price or incentives come later. Moreover, you should also think about why the seller is offering so many incentives. It is either a shrewd marketing and sales gimmick or the quality of the product is doubtful. Another reason to be cautious is that it might drag you into a speculative activity the result of which will not be in your control.

Restraint Bias

Restraint bias occurs when you overestimate your ability to show restraint in the face of temptation. It is normally associated with eating disorders and various addictions.

In the markets, it refers to one’s inability to follow a pre-defined process, while buying and selling, due to attractive prices. For example, you have pre-decided that in your portfolio, no item will be worth more than 10% of the total value. Due to some news or a drastic drop in price, something looks very tempting and you buy more of it, resulting in significantly disturbing the balance of your diversified portfolio.

Restraint bias is best captured by an apt quote from Oscar Wilde, “I can resist everything except temptation”.

Remedy

In this regard, the importance of having a pre-meditated system of how you will operate in the market cannot be overemphasized.

Availability Heuristic

Availability heuristic refers to the tendency of human mind to make a decision on the basis of information that becomes readily available, regardless of whether it will affect the quality of the decision positively or negatively. For example, what is shown on electronic media 24/7 doesn’t represent the complete picture of a particular issue but still, it affects the decision-making at various levels significantly.

In the market also, since the price of an item is what you see all the time, you can be unduly biased while buying or selling.

Remedy

Slow down and try to know all possible aspects and angles of a problem and then make a deliberate decision.

Co-relation is not Causation

It means that just because two things or events are co-related doesn’t mean one causes the other. However, the human mind may interpret co-relation as causation which is one of the cognitive biases. There can be many examples of this bias. For example, if someone is intelligent as well as rich, it doesn’t mean he is rich because he is intelligent. There could be 100 other reasons for him being rich and his intelligence might also have played a part. The gambler’s fallacy, explained earlier, is also an example of co-relation being misinterpreted as causation.

As already mentioned in this article, since the human mind has a bias towards finding patterns and shortcuts, it is likely that if a co-relation occurs frequently, it may be interpreted as causation. We need to be mindful and aware of this tendency while making decisions.

Remedy

Be careful while analyzing data. See all aspects of a problem dispassionately and do not fall for easy answers.

It means your personal failure to notice your own cognitive and emotional bias despite failures and setbacks.

It is said that we live on the other side of our eyes. We may have the capacity to analyze a situation better if we are not personally involved in it. You might have observed people who take a personal or emotional position on a social or political issue insisting that they are right and the people subscribing to the opposite views are wrong. These are all examples of blind spot bias.

In the markets also this bias occurs frequently and is responsible for many losses people make unwittingly.

Remedy

Be humble and a consistent learner. Slow down, meditate and breathe deeply. Prefer reading over watching TV. Resist the temptation of absolutizing and generalizing. Always be ready to accommodate exceptions to rules.

Conclusion

Biases, cognitive as well emotional, are natural. No one can claim to be free of those. However, to whatever extent possible, we should make a consistent endeavor to be aware of their presence and see how they are affecting our behavior and choices. In financial matters, rationality has a higher premium, therefore, we must learn to identify and rein in our biases for better results.

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My other articles you may find useful are:

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Why I Started a Blog on Personal Finance

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