Have you ever made a big money decision that you regret? It happens to all of us. Like it or not, we come preloaded with a variety of biases, brain glitches that lead to bad decisions about money and other important issues. So how do we defend ourselves from ourselves? Start with this list of three cognitive bias traps. Once you recognize them you have a better chance of avoiding them.
Heads I’m Right, Tails You’re Wrong — Confirmation Bias
We all want to be right. This “right desire” triggers confirmation bias. It causes us to seek out information that proves our point and actively ignore facts that are contradictory. That’s why Democrats listen to liberal NPR broadcasts and Republicans tune in to conservative Fox News. Politically unbiased individuals would listen to both sides to gain a fair and balanced perspective. It rarely happens.
Think about a time you purchased stock in a company you had to own because it produced a product you enjoyed using. in doing so you might have ignored or discounted negative information that contradicted your instinct to buy, such as poor earnings or too much debt. Twitter is a good example of an attractive product without profit; its stock is down from a high of $69 to its current price of $27 (-60%). Groupon is down even more, from $26 to $4 (-85%). Many bought these stocks based on confirmation bias of things they liked about the companies, ignoring facts that told a different story.
Not Right Now — Regret Aversion
“I’ll look at this next quarter, month, week, after the holiday, etc..” Avoiding an action out of fear of making a poor choice is known as regret aversion. Regret aversion is especially acute when the pain of regret is stronger than the pleasure of success, which is often the case. Because a bad investment decision can wipe out years or even decades of hard earned capital, it’s often easiest to simply postpone and postpone again. But waiting can be very expensive too as the market may not wait for you, leading to sad stories long after of “coulda, woulda, shoulda.”
I Can Beat The Market — Overconfidence Bias
We’ve already said that people like to be right. It turns out we often want to feel like we’re right even when we’re not. If you listen to cocktail party chatter about stocks, you’re much more likely to hear about the time someone made an instant $5,000, not about the time they lost $50,000. This selective memory is a manifestation of overconfidence bias. It’s a natural tendency to think we are better employees, better athletes and better investors than we really are.
Overconfidence combined with instant access to endless online information creates the illusion of a market edge – that is, an ability to pick outperforming stocks. But evidence shows individual investors who pick stocks rarely match the performance of the S&P 500. In fact, professional money managers lag the S&P in most years, on average.
So, what is an investor to do? How can you overcome these pervasive biases? Step one is simply: Awareness. Simply acknowledging that you are susceptible to these risks can help to avoid them. Ask yourself:
Am I using my skeptical eye? Am I ignoring information that leads to a different conclusion?
Am I letting fear of making a mistake get in the way?
Is this decision based on reality, or on inflated confidence in my ability? Am I missing the bigger picture?
Above all, remember that the majority of investors significantly underperform the market due to simple behavioral reasons. Understanding your innate biases can help you find a better path. Further, an unbiased professional advisor can act as valuable buffer between your emotions and your money.
Max Osbon – firstname.lastname@example.org