Behavioural Finance 101: Cognitive Bias
Being aware of cognitive biases can help us make better investment decisions.
Every day, we make thousands of decisions; some put that number as high as 35,000. The vast majority are routine and without especially big consequences – but then there are the ones that matter a lot more.
Choices about investments generally fall into the “important decisions” category because what we buy, when we buy, how long we hold it and when we sell can have a significant impact on long-term financial well-being.
Yet every decision, large and small, can be influenced by myriad cognitive biases. Many of these are hard-wired into our brains to help us manage all that exhausting decision making and, in some cases, make life-or-death decisions extremely quickly.
“[Cognitive biases] are an evolutionary adaptation,” explains Dr. David Lewis, PhD, chief client officer at the behavioural economics consulting firm BEworks. “Our brains have evolved to have a very fast, non-analytical way of thinking. When confronted with danger, it doesn’t make a lot of sense to sit down and analyze what to do. It usually makes more sense to just do anything rather than deliberate.”
The trouble is that mental shortcuts, known as heuristics, can lead us to make decisions that impact us in negative ways. The good news, says Lewis, is that simply being aware of the fact that cognitive biases exist can make us pause, engage in “metacognition” (thinking about thinking) and start to make better decisions.
Who wants to lose?
You’re invited to lunch with someone who can make your career – but you hesitate. What if you spill food on your lap? What if you have a coughing fit? Do the risks outweigh the benefits? Maybe it’s safer to turn the offer down.
One of the cognitive biases that can lead investors astray is loss aversion. No one wants to lose. And, in fact, people are said to feel the pain of a market loss twice as intensely as they feel the joy of a market gain. However, loss aversion can lead to decisions that harm long-term investment returns.
“Investors may not take enough risk to get the level of return they require to achieve their wealth objectives in the short, intermediate or long term,” says Lewis. “They tend to focus too much on short-term factors and avoiding risk, and the result is long-term underperformance.”
Beyond keeping assets in a portfolio that’s too “safe” to achieve their goals, loss aversion can actually convince investors to take more risk to avoid loss – for example, holding onto an investment to avoid realizing a loss when they should sell it, or trying to make up for a loss by buying inappropriately risky investments.
If you don’t want loss aversion to govern your decision making, it’s worth making a clear division between the money you’re growing for the long term and the money you need to cover shorter-term spending and emergencies. A short-term loss matters a lot if you need to access your money tomorrow – but it shouldn’t be the primary reason for an investment decision in an account that’s geared towards long-term growth.
Just how sure are you?
You’re looking for a new stove, so you pick your model and then scan websites searching for the best price. You find a great deal – but you wait. Surely prices will drop further, you think. A friend who works at the store says, “Buy now – that’s as low as you’ll find it!” You ignore them, convinced you know best, and then prices go up instead of down.
Some investors can be overconfident, believing they can predict the markets better than they really can. That can lead them to try to time the market – attempting to buy at the bottom and sell at the top. They may overtrade, incurring expenses that diminish their returns and ignoring the risks associated with active trading. Overconfidence can also mean they won’t listen to anyone else’s opinion.
“People tend to overestimate their own abilities, and that leads them to refuse professional advice,” says Lewis. “That just reinforces the errors.”
One strategy to overcome the overconfidence bias is to deliberately pause before acting on the assumption that you know best. Take the time to think through the repercussions of what you’re about to do – good and bad. Consider the possibility that your decision may put your long-term planning at risk – for example, delaying the date you can retire.
Finally, make a conscious effort to listen carefully to what others are saying, even if it disagrees with your view. Keep in mind, says Lewis, that research shows people who have received professional training in investment management, economics and finance tend to be more rational, less emotional decision makers – so your advisor is worth paying attention to.
Is it all about the “now”?
You get a bad cold and spend a few days in bed. It feels interminable. In fact, you can’t remember what it felt like to be healthy. All you can think about is the cold. Finally, you recover. And, suddenly, it’s hard to remember what it felt like to be sick.