Last week we looked at four types of “stinking thinking,” cognitive biases that can contribute to poor investment decisions. Here are six more.
- Monte Carlo Fallacy. This is placing too much emphasis on the likelihood of an event happening, just because it hasn’t happened recently. Think of the last 13 years of rise in the stock market. Many investors started betting that stocks would crash after rising for four, five, ten, or twelve years. Yet that history is statistically meaningless. The odds of a market going up or down every year are about the same, regardless of what has happened in previous years.
- Overconfidence. Many people feel they have information or research that is so good, they know what is next. As a professional investment advisor, I experience this occasionally when a client values their “gut feeling” above any empirical data or years of education their investment advisor may offer. One recent example of overconfidence bias was those who “knew” the stock markets would go down immediately if Joe Biden won the 2020 election. Instead, the market had the second highest advance in history.
- Confirmation Bias. This is the tendency to only look for data, instances, or research that confirms what we already “know is true.” If you were convinced that markets would crash if Joe Biden were elected president, then you would have looked for information supporting that position, and you would find plenty of reinforcement. It would serve us better in such cases to look for information that contradicts our firmly held beliefs. This may help us make more thoughtful and balanced decisions.
- Loss Aversion. This is placing more emphasis on avoiding loss than on the possibility of gain. It results in investors wanting to have their cake and eat it too by searching for an investment with a high return and low or no risk. When they discover such investments don’t exist, many people don’t invest at all. Others go into an investment expecting it won’t go down, then sell out at precisely the wrong time when it does.
- Delusion. This is an attitude that “bad things only happen to others, not me.” A deluded investor is one who holds onto an investment even when it is apparent that it’s never coming back.
- Narrow Framing. This is making a quick decision without gathering or being aware of all the facts and considering the implications. Usually, the investor doesn’t uncover “the rest of the story” until it’s too late and the financial damage is done.
The study of cognitive bias as it applies to investments 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 trauma that cause cognitive bias.
Making rational investment decisions requires, not only the ability to process our own emotional impulses, but the knowledge and imagination to anticipate consequences.
During a stock market decline, those who sell out focus on the relief from anxiety that it may bring. Those who stay in or increase their investments may have the same initial impulse. Yet they override it by first using their left brain to access the knowledge that market cycles are normal. Next, they switch to the right brain to imagine the anxiety that would come with missing out on gains when the market does recover.
All of us have cognitive biases that affect our financial decisions. Understanding that most of us make financial decisions that are not in our best interests is a good first step toward learning to make ones that support our financial wellbeing.