Cognitive and emotional biases often prevent us from making the most of our money – but which regularly do us the most harm?
While the pool of potential ‘thinking traps’ flows deep and wide – as evidenced by countless academic and scientific studies1 – we highlight some of the more common causes that compel us to lose our objectivity and take the mental shortcuts that lead to poor investment decisions.
Closely linked with ‘regret aversion’, this bias can stop us from making a decision which could incur a feeling of loss. It is related to Daniel Kahneman and Amos Tversky's (1979) Prospect Theory and their famous assertion that “losses loom larger than gains”. Because we don’t want to conclude that we have made a poor decision, loss aversion may help to explain why we can be slow to sell a failing investment or reverse an ill-considered action.
Often viewed as one of the most pernicious of human biases, overconfidence leads investors to think they know more than they do – and to act accordingly. One of its effects is for individuals to trade more often than they should (a costly pursuit), because they believe they have the skills to time the market. This is usually an illusion, as we explore in more detail here.
When making a decision we are often persuaded by information which is readily available or which is familiar to us. If it’s in the news or we can recall it easily we deem it to be important. The implications for investing can be profound: people may invest in a prominent company (that has a powerful command of how the media works) without assessing whether the actual fundamentals are sound.
Availability bias also helps to explain why we may make a decision based on a singular economic event or news release (such as a lower GDP figure) when a broader or long-term view may be more prudent.
It is not unusual to follow the herd – we find safety in numbers. Yet the crowd is not always right, nor wise, so blindly copying the actions of the many can lead us into financial trouble. Wildly popular stocks and the fear of missing out can frequently mean our money is taken for a ride if we don’t ask the right questions.
From the Dutch tulip bulb mania of the 17th century to the dot-com bubble to the meme stocks craze of the past couple of years, the perils of herd behaviour are persistent, as we examine here.
First impressions count, but we shouldn’t always rely on them. Confirmation bias means that we are more likely to take notice of information that reinforces our beliefs and outlook – while ignoring other salient facts.
This behaviour prevents us from exploring opportunities which may be to our benefit, as we tend to look for information that supports how we already think. For example, we might believe that active fund management is a price worth paying, even if the facts show this is rarely the case, even in a downturn.
Status quo bias
We often favour a path of least resistance. This could be for a good reason: we might not have enough information to make a decision, so we may prefer to leave things as they are. Any change from the status quo, therefore, is emotionally felt as a loss and helps to explain our inertia even though taking action could be to our advantage. This inaction often affects our finances – for example, if we stick with a costly standard rate mortgage or persist with investments that charge high fees.
Taking stock of these biases
Being aware of these biases doesn’t prevent them from taking hold or producing conflicting messages – we may over-trade on one hand, while also suffering from inertia. But their effects may be mitigated with a little insight into how they assail our emotions and derail our reasoning.
A way to overcome any biases is to look at information objectively – and to try and assess the difference to our wealth that taking an action, or not acting at all, will make.
We may also reduce the impact of our cognitive and emotional shortcomings by choosing a company to diminish their grip on our senses. At Netwealth, our investment professionals have a wealth of experience in handling the biases that individual investors typically face as we build efficient, diversified portfolios with a long-term strategic outlook in mind.
Please note, the value of your investments can go down as well as up.
1 These include Prospect Theory, the Disposition Effect and Nudge Theory.