Why cognitive bias is the investor’s biggest foe Your emotions can get the better of you when you’re making investment decisions. We look at how to identify and deal with the most common cognitive biases.
Iwas giving a presentation on the psychology of trading last week. One of the main points I addressed was about the many cognitive biases that traders have. Businessdictionary.com defines cognitive bias as a “common tendency to acquire and process information by filtering it through one’s own likes, dislikes, and experiences”. My presentation was about trading, but as investors we’re no less susceptible to these many cognitive biases, and there are literally hundreds of them.
One of the most common biases we suffer from is confirmation bias. This bias refers to how we give more weight to information that conforms to our beliefs and largely ignore information that goes against our beliefs. This seriously skews our ability to rationally evaluate a share. For example, if we only ever order a craft beer when out drinking, we’re likely to feel that the major brewers (SABMiller/ AB InBev) are doomed and craft beer will be their downfall. Sure, craft beer is growing, but it is a million miles from ending the major brewers’ dominance.
The problem is made worse by the internet – no matter what you believe, you’ll find supporting views online.
The solution here is to always seek out and read opposing views and work with a pair of standard checklists. The first list is used to verify the information you’re reading. Is the author always beating one drum? How right have they been in the past? Do they proudly claim their beliefs as an important part of who they are? What of opposing views, do they dismiss them out of hand or actually tackle them and rebut in detail?
The second checklist is company specific. It is a list of what you’re looking for in a company. Say you want to see revenue increases over the last five years. Having this on a list forces you to check that box or leave it blank. You can’t just skip over this information as it’s right in front of you and forces you to deal with the issue.
Another important cognitive bias we need to be aware of is optimism bias. Here we believe that we’re less at risk than others. There are a number of reasons why this belief can arise but, for example, if you work for a large listed company you many assume you know the company better than others. But unless you’re in a very senior management position, the reality is that you only have a small sliver of inside information, but not anything of significance.
I recently met somebody who works for a listed company. He was singing the praises of their stock. Nothing I said would dent his enthusiasm and he just brushed aside my hard questions by commenting that I didn’t understand and wasn’t an insider. Sure, maybe I didn’t understand, but that was why I was asking the questions – questions he was unable or unwilling to answer. Frankly his knowledge of the entire business was very limited and yet he had 100% of his investments in the stock. The encounter reminded me of the events that transpired at Enron – right up until the very end, insiders were singing its praises too.
I have stated many times that the biggest risk to our portfolio is us. We buy badly, sell poorly and generally make mistakes that cost us money and ultimately dent our retirement savingsdue to poor performance. Many of these mistakes are the result of a cognitive bias and we need to be ruthless, not only in seeking them out, but also in finding ways to remove them from our investment processes.
We need to be only in seeking them out but also in finding ways to remove them from our investment processes.