In the complex world of investing, our decisions are often influenced by cognitive biases. These biases, deeply rooted in our psyche, can lead us to make irrational financial choices. Despite the growing popularity of behavioural finance and educational resources, understanding these biases is only the first step. The real challenge lies in overcoming them.
When it comes to investing, a deeper understanding of cognitive biases and their impact on investment decisions could provide valuable insights for effectively navigating and mitigating their harmful effects.
What is Cognitive Bias?
The CFA field guide of behavioral biases groups biases into two camps: emotional biases and cognitive errors. The first step to overcoming bad investment decisions from behavioral biases is to determine which bias you are more susceptible to.
Emotional biases stem from impulse or intuition and lead to faulty reasoning owing to the influence of feelings such as fear, greed, or remorse. These biases are more difficult to overcome than cognitive biases because it’s tough to control emotional responses to the experience of losing or making money.
Cognitive errors stem from faulty information processing or recall. These are split between two types. First is belief perseverance, which is the tendency to irrationally stick with current beliefs. These decision-making errors could stem from selective exposure, perception, or retention of new information. Processing errors are the second type. Instead of failing to adjust to new information, these errors are caused by shortcuts that we use to make decisions quickly. Cognitive errors represent the limits of the human mind and tend to be easier to correct than emotional biases.
In the context of investing, individuals may be prone to various cognitive biases that can impact their financial decisions. Some common cognitive biases in investing include:
- Overconfidence bias,
- Confirmation bias,
- Anchoring bias,
- Loss aversion,
- Herding behavior, and
- Recency bias.
The Challenge of Overcoming Biases
These biases are hardwired into our brains and are the result of thousands of years of evolution where they served a purpose, says Devina Mehra, founder and chairperson of First Global, a leading Indian and Global investment Management firm. “Evolution is frankly not interested in our portfolio or investments,” she says. “Its only focus is on our survival and procreation.”
The loss aversion bias, for instance, prevents us from admitting our mistakes and booking losses in the stock market. The bias has its evolutionary roots in the hunter gatherer days or early humans. The constant fight for survival in the wild conditioned humans to act when they perceive threat.
In today’s terms, this has resulted in a mindset that is more concerned about negative consequences than positive outcomes of similar proportions, says Mehra. “In the markets, it means that a Rs 1 lakh loss will make us far more unhappy than the happiness we may find in a Rs 1 lakh profit,” she contends.
Similarly, the herd mentality, ingrained in humans from tribal times, compels individuals to blindly follow others. It once functioned as part of the survival instinct, rooted in avoiding social exclusion and ensuring reproductive opportunities.
With in the investing world, the surge in new fund offerings, including thematic options like Nasdaq ETFs, small-cap funds, and industry-specific funds, exploits our natural tendency to follow the crowd, Mehra notes.
“If you want to get over it, remember there is no need to have the fear of missing out (FOMO) as opportunities are like buses -- if you miss one, the next one will come along,” she says.
The entire thematic fund business is predicated on the desire of human beings to get on whichever bandwagon everyone is climbing onto, she adds, stressing the conscious avoidance of thematic funds.
Another effective method to minimize the impact of herd instinct is to limit discussions about your investments. “Do not discuss them in person or on WhatsApp/Telegram groups, not at least until you have done your own analysis and come to your own conclusions,” Mehra argues.
These biases are hard to eliminate. Even when the mind understands their existence, it continues to see things from the prism of those fallacies. “Being conscious of them and by putting certain rules in place, you can somewhat reduce the impact for a handful of those biases,” says Mehra.
Recognize Your Own Biases
Managing biases in investment involves cultivating self-awareness to recognize potential cognitive pitfalls. Adopting a systematic decision-making approach through research and analysis, and seeking diverse perspectives can help mitigate the impact of biases and enhance overall investment strategy.
“If you are looking at the performance of small cap mutual funds do not start with all the mutual funds that exist today and look at their performance for the last number of years,” says Mehra.
The analysis has to account for those small cap funds that once existed but have been since shut down or got folded into other schemes due to poor performance. “If these are not included in the analysis, it will inflate the value of the returns,” Mehra warns.
To counter the impact of the loss aversion bias, she recommends putting “a ‘stop-loss’ system in place and be disciplined about sticking to it; not making excuses if a stock hits a ‘stop-loss’ limit,” she says. Mehra admits it is not possible to remove all our cognitive biases, except through a system. “If you want to buy stocks with specific characteristics, put that as a system and then actually buy all the stocks that meet those criteria,” she notes.
Mehra is also a proponent of the strategic use of artificial intelligence to remove or reduce human biases from the investment process. “We at First Global use an elaborate artificial intelligence and machine learning system which drives our best-in-class returns,” she says, stressing that a well-designed system will outperform so-called human experts by eliminating both biases and random noise, introduced every time human judgment is involved.
How to Overcome Biases
Cognitive errors stem from poor information processing and overconfidence in our ability to predict or influence market outcomes, leading to bad decisions. For example, resisting the urge to trade when faced with new information can be tough to overcome. But you’re likely better off not trading based on "new" information that you read in Barron’s or hear on CNBC. Since everyone has access to that news, it probably won’t lead to market-beating performance. Frequent trading can lead to excessive transaction costs or realized taxes, which detract from performance.
Cognitive errors can lead to the impression that we can take actions to beat the market, even when the odds are long. The good news is that cognitive errors are easier to address than emotional biases because they represent limits in logic or calculations rather than deeply seeded impulses. Checking your decision-making logic and finding gaps in thinking are often the best ways to avoid cognitive errors. The following strategies may help mitigate their effects.
- Hit pause. Often times when making an investing decision, the benefits of waiting a day or a week to make a decision outweigh the penalty for not acting fast. Slowing down the decision-making process will allow the time to collect necessary information to make a more informed decision. Sometimes, the best thing to do is nothing at all.
- Keep an investment journal. Documenting your thought process leading up to an investment decision can help keep yourself in check. Use consistent sections in your journal to create a time series of decisions to find where you consistently make strong or poor decisions. For example, you could habitually overestimate the risks of an investment decision. Knowing this information could help you adapt future decisions to incorporate this known cognitive bias. Keeping a journal can also help you keep track of skillful versus (un)lucky decisions. Did the decision pay off for the reasons that you had anticipated or because of events that you hadn’t considered?
- Have a devil’s advocate. Find a friend, financial advisor, or family member to check your investment logic and highlight your blind spots. The goal here is to help strengthen your thinking before making the decision. The best candidates for this role are those that exhibit sound logical thinking, aren’t afraid to point out when you’re wrong, and are willing to put in the time. This is a two-way street. An investing partner will appreciate it if you exhibit the same characteristics when serving as a devil’s advocate for them.
Understanding Noise in Financial Analysis
We've touched on biases, but what about noise? Consider this: if we provide identical financial and company data to 10 analysts, they'll generate 10 different views on the same information. Furthermore, Mehra says, even the same analyst may interpret the data differently based on factors like their emotional state on a given day.
The key to evaluating systems is to not expect them to be error-free. “The criteria to use is not whether the system is perfect but whether it is a better alternative to human decision making,” contends Mehra.
Using a cricket analogy, she says that in the game, the question should not be whether the technology-based DRS system, frequently used to assist on-field umpires’ decisions, makes no mistakes, “but rather whether it makes fewer mistakes than a human umpire.”
All told, mitigating cognitive biases is crucial in investing. Recognizing these mental quirks is essential for investors to make more informed and rational decisions. Implementing strategies to mitigate these biases enhances decision-making and promotes a more rational approach to navigate financial markets.