Many long-term investment strategies are derailed by cognitive investment biases. Cognitive biases can trip up even the most experienced investor, and it makes sense to be aware of the biases our brains are hard-wired for. These systemic errors can impair our judgement and lead to poor decision-making, especially when it comes to investing. Here’s what to look out for.
Anchoring is a bias that affects us all and is difficult to avoid. Generally speaking, the anchoring bias causes us to rely too heavily on the first piece of information that we are provided. Anchoring happens regularly in price negotiations such as when you are buying a home or car, where the first price that is put on the table becomes the anchor to which all other offers are linked. The fact that the first number may have been randomly adopted by the seller with no specific link to intrinsic value means that all negotiations that follow are not grounded in actual value. Salary negotiations are an excellent example of anchoring where the first salary offer made generally becomes the anchor to which all subsequent offers and counter-offers are made. The anchoring bias focuses discussions on a particular price point rather than to the intrinsic value of the subject being negotiated. From an investment perspective, investors succumb to anchoring when viewing a current share price relative to its trading history rather than the price of the share in relation to its intrinsic value.
Confirmation bias is something that most of us are guilty of, and this bias is demonstrated frequently on social media platforms. Confirmation bias compels us to actively seek out information, statistics or theories that confirm or support our existing beliefs, while at the same time deliberately avoiding information containing opposite views to ours. In doing so, we intentionally seek out information that proves our theory or belief to be right so as to avoid confronting the possibility that we may be wrong. This bias has been well-demonstrated through the coronavirus pandemic, where conspiracy theorists actively seek out and share material that supports their theory while intentionally ignoring data that proves the opposite to be true.
In the context of investing, this bias can be dangerous because it can lead investors to remain in inappropriate strategies simply because they don’t want to process information that suggests their strategy is ineffective. Research has also found that the more a person openly makes others aware of their view or opinion, the less likely they are to change their opinion – and this is referred to a ‘commitment bias’. This could go a long way to explain how people fall victim to investment scams and remain committed to the scheme despite overwhelming evidence to the contrary.
The availability bias, or availability heuristic, causes investors to create a mental shortcut that relies on the most immediate information that comes to mind, rather than the most appropriate information. For example, an investor might decide to buy Bitcoin because the most recent article he read was about a person who made millions through cryptocurrency. While the content of the article may have been true, the investor gives the information credence because it is the most recent information he has processed and not because it is the most complete assessment of Bitcoin. Retailers regularly play on our availability bias because they know that, for many of us, the last advert or billboard we see before reaching the mall has the potential to be top-of-mind simply on the basis that it’s the most recent information we’ve processed. Giving preference to the most recent investment information you have received may result in you not doing your due diligence or failing to consider other investment options at your peril.
As humans, we are hardwired to avoid making losses to the extent that we will hold onto something that we own even if we are losing money by doing so. This is known as loss aversion, or the endowment bias, which leads us to place greater value on things that we own – including shares – than things that we don’t. From an investment perspective, the endowment bias is difficult to overcome because the investor made a conscious decision to invest in a particular share or strategy and, even if the strategy is a loss-making one, the investor may refuse to change strategies in the hopes of making their money back. This bias can result in investors missing out on excellent investment opportunities while their money is tied up in loss-making funds.
Optimism bias and over-confidence
According to some researchers, our tendency towards being optimistic is a result of evolution – and that our survival depends on our ability to be confident and optimistic when faced with challenges. An over-confident investor, despite his inexperience, may convince himself that positive outcomes are more likely despite evidence to the contrary. An everyday example of optimism is people unnecessarily placing themselves at risk of contracting the coronavirus despite evidence that the virus is highly contagious. Believing that you will escape the virus despite warnings from medical experts is a simplistic, but useful example of optimism and over-confidence.
When it comes to investing, many investors avoid seeking investment advice because they are hardwired to believe they are able to do it better themselves. Of course, when they realise their shortcomings, they face the possibility of succumbing to loss aversion, thereby perpetuating the impact of biases on his investment decisions.
Information bias is our tendency to focus on information that, while interesting, is not pertinent to our circumstances. In many instances, it is the information bias that tempts would-be long-term investors into speculators. Instead of remaining focused on the long-term trajectory of their share portfolio, many investors become hyper-focused on daily stock market fluctuations which, in turn, causes them to buy shares and time markets rather than stick to their original buy-and-hold strategy.
Reactive devaluation bias
Reactive devaluation is the tendency of an investor to bestow greater value on a proposal or recommendation that emanates from someone that he likes. Where the same proposal comes from someone he does not like, the investor will place less value on the information. Reactive devaluation can influence an investor’s decision-making where he feels animosity towards, or intensely dislikes, the person giving him advice. Rejecting sound investment advice simply on the basis that you don’t like the person can lead to poor decision-making and investment outcomes.
The bandwagon effect, or groupthink bias, operates on the assumption that there is ‘safety in numbers’. Investors take comfort in knowing that ‘everyone is doing it’ and believe that ‘everyone can’t be wrong’. Investing in a share because everyone else is doing the same is fundamentally flawed decision-making, primarily because your decision is not being based on research and analysis but rather on the actions of the collective. The bandwagon effect can be exacerbated by another important bias, namely the fear of missing out.
Fear of missing out (FOMO)
FOMO is a cognitive bias that an individual investor may succumb to based on his fear of missing out on a good investment opportunity, especially if lots of other investors seem to be following suit. FOMO is a dangerous bias because it can lead to jealousy, dissatisfaction and self-doubt. Those who are invested for the long-term are susceptible to the fear-of-missing-out bias especially when hearing market speculators talk about their short-term wins. Feelings of FOMO are intensified because, generally, by the time they hear of the short-term wins, the investment opportunity has already passed.