When it comes to investing, we’re all aware that what we don’t know can hurt us. That’s why we spend time doing research on stocks, ETFs, companies that are poised for strong long-term future growth such as those in the biotech field, green tech, unified communications solutions — and the list goes on.
But sometimes, it’s what we think we know — but isn’t actually the case — that can hurt us even more. With this in mind, here are three types of cognitive biases that can, and often do, lead to huge investment mistakes and possibly a lifetime of regret:
Confirmation bias refers to the tendency to filter out information that doesn’t align with a preconceived notion. For investors, this often manifests as overconfidence in their positions despite clear and convincing evidence to the contrary; that is until they invariably must face the harsh reality outside of their heads.
Loss aversion refers to the tendency to disproportionately prefer avoiding a loss vs. generating a gain. Sometimes, this can be quite helpful. For example, while traveling in an unfamiliar city we may feel strongly compelled by curiosity to wander into what seems like a dangerous area. However, we (wisely) choose not to do so, because the fear of loss — i.e. getting mugged, attacked, or harmed in some way — is stronger than the desire for adventure. But there are scenarios where loss aversion is a liability instead of an asset. For example, investors who have an unhealthy aversion to loss hold onto unprofitable and money-losing investments, not because they necessarily expect them to turn the corner in the future (although this is what they tell themselves and others), but because the idea of taking a loss is intolerable. Unfortunately however, these investors eventually run out of options, and often incur steep losses that are far bigger than they could and should have been.
Recency bias refers to the tendency to be heavily influenced by recent information, to the extent that valid historical information is discounted or outright ignored. Sports books in Las Vegas and other locations love retail gamblers who suffer from a bad case of recency bias, because these folks overestimate the value of fresh performance data and analysis — and sooner or later end up losing more than they win, because they don’t factor in all of the available, credible information. The sad story for investors is similar.
The Bottom Line
Avoiding cognitive bias is difficult; and for some people, it can be impossible. After all, we’re human and as noted above, some forms of cognitive bias in certain situations can be helpful (and possibly even life-saving). The best advice is for investors to develop and stick to a robust plan that aligns with their resources, goals and tolerance for risk. Getting help from qualified, independent experts can be quite valuable as well. Sometimes we need another pair of eyes to help us see what’s right in front of us — and what isn’t!