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.

Finweek English Edition - - MARKETPLACE - Ed­i­to­rial@fin­week.co.za

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.

Con­fir­ma­tion bias

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.

Op­ti­mism bias

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.

Newspapers in English

Newspapers from South Africa

© PressReader. All rights reserved.