Cognitive Biases in Investment – and how to Mitigate their Effects
When it comes to investment, fluctuations in prices, the availability of information and volatile economic conditions all play a part in the decisions that investors make. Behind all of this, though, is a whole suite of cognitive biases that sometimes lead to poor investment decisions. Simply put, a cognitive bias is a natural, hard-wired, systematic error in thinking that just about everyone is liable to make from time-to-time, and includes things like oversimplifying complex decisions, taking shortcuts, and being overly confident in our decision-making processes. The cognitive biases we’ll cover here aren’t the “be all and end all” (plenty of others are prevalent), but they are common in investment, and we’ll show you how you can mitigate their effects so your investment decisions aren’t negatively impacted.
Confirmation bias involves only looking for (or over-emphasising) information that confirms our pre-existing conclusions. As far as investment is concerned, it can lead people into a false sense of security when data appears to show an investment that can’t fail. This overconfidence increases the risk of being blindsided if something does go wrong. How to mitigate: Challenge the status quo! Look actively for information and data that challenges your assumptions and investment thesis. Make sure you continually revisit your investment, and take a balanced look at why you may be wrong, as well as why you may be right.
Information bias is the tendency to evaluate all information you receive, even when it isn’t useful or relevant to the decision you’re making – and in the investment world there is plenty of outside information that bombards investors, regardless of its relevance. For example, daily share price updates aren’t all that useful for investors interested in the longer-term prospects of their investments. Putting too much faith in these shorter-term pieces of information can lead to poor buying and selling decisions. How to mitigate: Make the effort to ignore irrelevant information, particularly short-term price movements. Keep your eye on the bigger picture – and seek out information that lends itself to making that bigger picture clearer.
It’s natural for humans to seek understanding of complex matters by simplifying them – and in some cases, over-simplifying. Mistakes are often made because an investor has tried to oversimplify an inherently complicated investment matter, and poor decisions are made as a result. How to mitigate: Stay within your “circle of competence”, where your knowledge and experience is better formed, and know the limits of your knowledge.
Even though these three cognitive biases only scratch the surface of the different psychological factors in making investments, they are a good indication of the fact that even the most experienced investors are susceptible to those hard-wired habits and human tendencies, that could eventually lead to poor investment decisions. The key to reducing their impact is to understand each of them, know how to reduce their impact, and then make decisions having worked around them.
If you have any questions about your investments, or need any investment advice, get in touch with McKinley Plowman’s Wealth team today on 08 9301 2200 or visit us at www.mckinleyplowman.com.au.
Adapted from “10 Cognitive Biases that can Lead to Investment Mistakes”, Magellan InReview, Hamish Douglass.
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