Explaining different ‘cognitive biases’ and their effects
Human beings can never be completely objective in their decision-making. Everything we experience is filtered through a lens of our own likes and dislikes, experiences and beliefs.
This creates what psychologists call ‘cognitive bias’ – errors in thinking that can limit our ability to make rational decisions, including decisions about our investments.
It may not be possible to avoid all biases, but simply acknowledging that they exist and then making an effort to take them into account can reduce their effects.
Here are seven of the most common cognitive biases and their potential effect on investment strategies.
1. Biased by recent events
Our memory tends to put emphasis on things that happened recently, which means new information can seem more useful than older information.
Investors with recency bias tend to be strongly influenced by how well the market has performed in the recent past and behave as though this is bound to continue. If the market has been strong, they’re likely to take more risks. If it’s been weak, they might panic and sell low.
A long-term view presents a more realistic picture. For example, history tells us that markets eventually rally after a fall, yet someone with a recency bias might sell off their shares in a recession and miss out on an opportunity for longer-term gains.
2. The fear of missing out
When hordes of people are rushing to snap up a particular investment, it’s hard to believe they could all be wrong. It can also be hard to live with the fear of missing out. Yet the bursting of the internet bubble in 2000 showed just how dangerous this behaviour can be.
Investors who follow the herd tend to sell frequently in order to invest in the latest trend. But, by the time they invest, it could be too late to benefit and the leaders might already have moved on.
They might also miss out on mid- to long-term gains on their original investment. Potential profits could also be eroded by the cost of so many transactions.
It’s important to do thorough research and seek advice before jumping on an investment bandwagon.
3. Staying with what you know
It’s a well-known saying but ‘better the devil you know’ isn’t always true for an investor.
Staying within the comfort zone of a particular location or type of investment, such as domestic shares, could mean missing out on significant benefits elsewhere.
Lack of diversification could also increase exposure to possible losses.
4. Thinking the future is predictable
With the benefit of hindsight, a past event can appear much more predictable than it was. Investors with hindsight bias tend to believe that if they or their advisers had only paid more attention they could have avoided a disappointing outcome.
This can lead to frustration and sometimes even the belief that if a past event was predictable, the future must be, too – and overconfidence and risk-taking can result.
Making a conscious effort to review past events impartially can help put gains and losses into perspective.
5. Overlooking contradictory information
It’s very common for people to pay close attention to information that supports their beliefs and to overlook any that doesn’t.
When they’re considering investments, it can cause them to ignore relevant facts, make dubious investments and hold on to a losing investment for too long.
That’s why it’s important for investors to search out and test contrary opinions.
6. Fearing regret
Also known as regret aversion, this is the desire to avoid the feelings we experience when we realise we’ve made a poor decision.
The fear of loss can make investors excessively risk-averse. Some overconfident loss-averse investors may be so reluctant to accept they’ve made an unfortunate choice that they “throw good money after bad” in an attempt to salvage a losing investment.
It helps to focus on overall performance rather than specific losses or gains.
Tips to keep biases at bay
- Try to identify any biases that might affect your decision-making.
- Do thorough research before making a decision and be open to information that challenges your assumptions.
- Seek professional financial advice.