Your Investment Strategy – Ten Cognitive Biases to Look Out For
Investing is as much about psychology as it is about numbers. While data and analysis play crucial roles in making informed decisions, the human mind is prone to cognitive biases that can cloud judgement and lead to suboptimal outcomes. A textbook definition of cognitive biases describes “systematic patterns of deviation from norm or rationality in judgment, often causing investors to make decisions inconsistent with their long-term financial goals”. In simpler terms – tricks our mind plays on us that hinders our ability to make good decisions.
The markets are volatile and complex already, so understanding these biases is essential if you are looking to navigate your investment strategy. By recognising and mitigating the influence of cognitive biases, you can make more rational decisions, reduce the likelihood of costly mistakes, and improve your chances of achieving investment success. Here are ten common cognitive biases that impact investment…
1. Overconfidence Bias
Definition
Overestimating one’s own abilities, knowledge, or judgement.
Impact on Investing
Overconfidence can lead investors to overestimate their ability to predict market movements or pick winning stocks. This might result in excessive trading, which often incurs higher transaction costs and can erode returns. Additionally, overconfident investors may take on too much risk, underestimating the possibility of adverse outcomes.
Example
An investor who successfully picks a few winning stocks may start believing they have a “golden touch” and begin trading more aggressively. This overconfidence might lead them to invest in highly speculative stocks or ignore diversification, eventually resulting in significant losses when the market turns.
2. Confirmation Bias
Definition
The tendency to seek out or interpret information in a way that confirms one’s preconceptions.
Impact on Investing
Investors influenced by confirmation bias tend to focus on information that supports their pre-existing beliefs while dismissing or undervaluing evidence that contradicts them. This can lead to poor investment decisions, such as holding onto underperforming stocks or failing to recognise emerging risks.
Example
An investor strongly believes in the future growth of a particular industry, like renewable energy. They seek out news articles and reports that support this view, ignoring warnings about potential regulatory hurdles or technological challenges. As a result, they might invest heavily in that sector and suffer losses when those challenges materialise.
3. Anchoring Bias
Definition
Relying too heavily on the first piece of information encountered (the “anchor”) when making decisions.
Impact on Investing
Anchoring bias can cause investors to rely too heavily on an initial piece of information (such as the price they first saw for a stock) and fail to adjust their views when new information becomes available. This can lead to suboptimal decisions, such as holding onto a stock that has dropped in value, believing it will return to its “anchored” price.
Example
An investor buys a stock at $100 and views this price as the “anchor.” Even after the stock drops to $70 due to deteriorating fundamentals, the investor might hold onto it, expecting it to rebound to $100, despite evidence suggesting it won’t.
4. Herding Bias
Definition
The tendency to follow the actions of a larger group, regardless of one’s own analysis or perspective.
Impact on Investing
Herding bias leads investors to follow the crowd, buying or selling assets because others are doing so. This behaviour can contribute to asset bubbles, where prices are driven up far beyond their intrinsic value, or to crashes, when everyone rushes to sell simultaneously.
Example
During a market rally, an investor notices that everyone around them is buying tech stocks. Without conducting their own analysis, they too invest heavily in these stocks, only to suffer losses when the tech bubble bursts.
5. Loss Aversion
Definition
The tendency to prefer avoiding losses rather than acquiring equivalent gains.
Impact on Investing
Loss aversion causes investors to fear losses more than they value equivalent gains. This can lead to risk-averse behaviour, such as avoiding investments that could offer higher returns, or to holding onto losing investments for too long to avoid the pain of realising a loss.
Example
An investor buys a stock at $50, but it drops to $40. Instead of selling to avoid further losses, they hold onto the stock, hoping it will recover, even though better investment opportunities are available elsewhere. Eventually, the stock continues to decline, leading to even greater losses.
6. Recency Bias
Definition
Giving undue weight to recent events or information over historical data or long-term trends.
Impact on Investing
Recency bias causes investors to give too much weight to recent events or performance when making decisions. This can lead to an overreaction to short-term market movements or recent performance trends, which might not accurately reflect the long-term outlook.
Example
After witnessing a sharp market decline over the past month, an investor might panic and sell their entire portfolio, fearing further losses. This decision ignores long-term market trends and historical data showing that markets often recover after such declines.
7. Availability Bias
Definition
The tendency to rely on readily available information or recent memories when making decisions.
Impact on Investing
Availability bias leads investors to rely on easily accessible information, such as recent news or memorable events, when making decisions. This can result in an overemphasis on recent trends or high-profile events, potentially causing investors to overlook more relevant but less prominent data.
Example
After seeing multiple news reports about a high-profile company going bankrupt, an investor might become overly cautious and avoid investing in other companies within the same industry, even if those companies are financially stable and have strong growth prospects.
8. Endowment Effect
Definition
Valuing an asset more highly simply because one owns it.
Impact on Investing
The endowment effect causes investors to overvalue assets simply because they own them. This can lead to irrational attachment to investments, making it difficult to sell underperforming assets or rebalance a portfolio when necessary.
Example
An investor holds shares in a company they inherited from a relative. Despite the company’s declining performance and the availability of better investment opportunities, the investor refuses to sell the shares because of their sentimental attachment.
9. Disposition Effect
Definition
The tendency to sell winning investments too early and hold onto losing investments too long.
Impact on Investing
The disposition effect leads investors to sell winning investments too early to “lock in” gains while holding onto losing investments too long, hoping they will bounce back. This behaviour can prevent investors from maximising their returns and from reallocating capital to more promising opportunities.
Example
An investor buys a stock at $20, and it rises to $30. Fearing a potential decline, they sell the stock to secure the profit, only to see it continue rising to $40. Meanwhile, they hold onto another stock that has dropped from $50 to $30, refusing to sell it despite its poor prospects.
10. Sunk Cost Fallacy
Definition
Continuing an investment based on the amount of money already invested, rather than the potential future returns.
Impact on Investing
The sunk cost fallacy causes investors to continue with an investment based on the amount of money or effort they’ve already invested, rather than the investment’s future potential. This can lead to throwing good money after bad or holding onto poor investments for too long.
Example
An investor has put a significant amount of money into a failing start-up. Despite mounting evidence that the business is unlikely to succeed, they continue to invest more money in an attempt to recoup their losses, rather than cutting their losses and moving on to more promising investments.
How Priority Can Help
Cognitive biases are an inevitable part of human decision-making, and they can significantly impact investment success if left unchecked. Whether it’s overconfidence leading to excessive risk-taking or loss aversion causing an investor to hold onto underperforming assets, these biases can detract from achieving financial goals. Recognising the presence of these biases is the first step towards overcoming them. A financial adviser (like those who make up our great team at Priority Advisory Group) can provide an objective perspective, helping you make decisions that are not only informed by data but also free from the distortions of cognitive biases. In doing so, you are better positioned to build and protect your wealth over the long term.
If you’d like to find out how we can help you grow and protect your wealth, please reach out to the team at 1300 349 188, or via our website.