Common Cognitive Biases: How Your Brain Can Trick You
🌟 Decoding Your Brain: A Guide to Common Cognitive Biases
In our last article, we introduced the concept of behavioral finance and the idea that investors are not always rational. Now, we're going to dive deeper into the specific mental shortcuts and flawed patterns of thinking—known as cognitive biases—that can sabotage your investment performance. These biases are not a sign of low intelligence; they are hardwired into our brains as evolutionary shortcuts that, while useful in other areas of life, can be disastrous in the world of investing. By learning to recognize these biases in yourself, you can begin to counteract their influence and make more deliberate, rational decisions.
1. Confirmation Bias: Seeking Evidence That Proves You Right
Confirmation bias is the tendency to search for, interpret, and remember information that confirms your pre-existing beliefs. If you've decided that a particular stock is a "winner," you will subconsciously seek out news, analysis, and opinions that support your thesis, while dismissing or downplaying any information that challenges it.
How it hurts you: Confirmation bias creates an intellectual echo chamber. It prevents you from seeing the full picture and objectively evaluating the risks of an investment. For instance, if you believe a certain electric vehicle company is the future of transportation, you might spend hours reading enthusiastic fan forums and positive analyst reports, while dismissing a critical report about their production issues as "FUD" (Fear, Uncertainty, and Doubt). This selective information diet means you might ignore genuine red flags, such as declining earnings or new competition, simply because they don't fit your established narrative.
How to fight it: Actively play the role of a "devil's advocate." For every investment you make, make a conscious effort to find and read the most compelling bearish arguments against it. If you can't find a strong counter-argument, you may not be looking hard enough.
2. Anchoring Bias: Getting Stuck on a Number
Anchoring is the tendency to rely too heavily on the first piece of information you receive. In investing, the most common anchor is the purchase price of a stock. If you buy a stock at $100, that number becomes a powerful psychological anchor.
How it hurts you: If the stock drops to $70, you might refuse to sell, thinking, "I'll sell when it gets back to what I paid." This is an irrational thought process. The market doesn't know or care what you paid for a stock; its current price is based on the collective judgment of all market participants about its future prospects. Your entry point is a sunk cost. The decision to hold or sell should be based on the company's future potential from its current price, not on your past entry point. Anchoring can cause you to hold on to losers for far too long, turning a small loss into a devastating one.
How to fight it: When evaluating a stock, force yourself to ignore your purchase price. Ask yourself: "If I had cash today, would I buy this stock at its current price?" If the answer is no, you should probably sell.
3. Loss Aversion and the Disposition Effect: The Fear of Regret
Loss aversion is the powerful psychological finding that the pain of a loss is about twice as potent as the pleasure of an equivalent gain. This leads directly to the disposition effect, which is the tendency for investors to sell their winning stocks too early and hold on to their losing stocks for too long.
How it hurts you: This bias, rooted in Daniel Kahneman's Prospect Theory, leads to the destructive habit of "cutting the flowers and watering the weeds." We sell winners early to lock in the pleasure of a gain and avoid the potential future regret of that gain disappearing. We hold losers because selling would mean making the loss "real," forcing us to confront the painful regret of having made a bad decision. This irrational behavior systematically leads to a portfolio of underperforming stocks, as you've sold your best performers and held on to your worst.
How to fight it: Implement a strict, rules-based system for selling. For example, use trailing stop-loss orders to protect the profits on your winning stocks, and have a pre-determined point at which you will cut your losses on a losing trade. This removes emotion from the decision-making process.
4. Overconfidence Bias: The Illusion of Knowledge
Overconfidence is the tendency to overestimate your own abilities and the accuracy of your information. In investing, this often manifests as excessive trading. An overconfident investor believes they can consistently time the market and pick winning stocks, leading them to trade in and out of positions frequently.
How it hurts you: Numerous studies have shown a strong correlation between high trading frequency and low returns. Every trade incurs transaction costs (commissions and bid-ask spreads), and frequent trading can also have negative tax consequences. Overconfidence also leads to the illusion of control, where investors believe they can influence or predict market outcomes. This might cause them to concentrate their portfolio in a few "high conviction" stocks, dramatically increasing their risk profile without a corresponding increase in expected return. Overconfidence leads to a "death by a thousand cuts" for your portfolio.
How to fight it: Be humble. Acknowledge that you are competing against millions of other investors, many of whom are professionals with more resources and information than you. Adopt a long-term perspective, trade less, and focus on the power of compounding.
5. Herd Mentality: The Safety of the Crowd
Herd mentality, or "herding," is the tendency to follow the actions of a larger group. This is driven by the fear of missing out (FOMO) when the market is rising, and by panic when the market is falling.
How it hurts you: The herd is often most bullish at the peak of a market bubble and most bearish at the bottom of a crash. By following the herd, you are likely to be buying high and selling low—the exact opposite of a sound investment strategy. In the age of social media, this effect is amplified. "Meme stocks" can soar to irrational heights based on social media hype, only to come crashing down when the herd moves on, leaving latecomers with massive losses. True investing requires the fortitude to stand apart from the crowd.
How to fight it: Cultivate a contrarian mindset. As Warren Buffett famously said, "Be fearful when others are greedy, and greedy when others are fearful." This doesn't mean you should always do the opposite of the crowd, but you should always be skeptical of popular opinion and base your decisions on your own independent research.
6. Recency Bias: Overvaluing the Latest News
Recency bias is the tendency to give too much weight to the latest information and to extrapolate recent trends into the future. If a stock has been performing well for the past few months, we tend to assume it will continue to do so, while ignoring its longer-term performance.
How it hurts you: This bias leads to trend-chasing. Investors pile into "hot" stocks or sectors at the peak of their performance, often just as the trend is about to reverse. It also causes investors to panic-sell during market downturns, as the recent negative performance overshadows the long-term history of market recoveries.
How to fight it: Always look at the bigger picture. When evaluating an investment, look at its performance over multiple time frames—one year, five years, and even decades if possible. Remind yourself that market trends are cyclical, and the hottest sector of today is often the laggard of tomorrow.
💡 Conclusion: Your Brain is Not an Investment Advisor
Cognitive biases are an inescapable part of the human condition. You will never be able to eliminate them completely, but by being aware of them, you can start to recognize them in your own thinking and take steps to mitigate their impact. Building a disciplined, rules-based investment process is the most effective way to protect your portfolio from the greatest enemy it will ever face: your own brain.
Here’s what to remember:
- Challenge your own beliefs. Actively seek out information that contradicts your investment thesis.
- Your purchase price is irrelevant. The decision to buy, hold, or sell should be based on future prospects, not past prices.
- Have a sell discipline. Know when you will take profits and when you will cut losses before you enter a trade.
- Trade less. Overconfidence leads to over-trading, which erodes returns.
- Don't follow the herd. The path to superior returns is often a lonely one.
Challenge Yourself: The next time you are considering making a trade, pause and write down the specific cognitive biases that might be influencing your decision. Are you buying because of FOMO? Are you holding a loser because of loss aversion? This simple act of self-reflection can be a powerful tool for improving your decision-making.
➡️ What's Next?
We've explored the internal, psychological forces that can impact your investing. But what about the external, mathematical forces? In the next article, "Quantitative Analysis: Using math and stats to make decisions", we'll shift from the art of psychology to the science of numbers, exploring how quantitative models can be used to find an edge in the market.
May your thinking be clear and your decisions be sound.
📚 Glossary & Further Reading
Glossary:
- Cognitive Bias: A systematic pattern of deviation from norm or rationality in judgment, whereby inferences about other people and situations may be drawn in an illogical fashion.
- Disposition Effect: The tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value.
- Contrarian Investing: An investment style that goes against prevailing market trends by buying assets that are performing poorly and selling when they perform well.
Further Reading: