Top 5 Cognitive Biases Of Investing To Watch Out For

Max Osbon - November 30, 2014

Last week, State Street’s Center for Applied Research released a fascinating thought piece on the common human traits that lead investors to sabotage their success. Falling prey to one or more of these naturally occurring cognitive biases can drastically change your investment outcome. Fortunately, simple awareness can be enough to help save us from ourselves.

Phantastic Objects – “A mental representation in which an imagined scene fulfills a person’s desires to have exactly what she wants. The imagination drives investors to see what they want to see in an investment. (Tuckett 2008)”

It’s easy to fall in love with alpha, the academic term for outperforming the market, as it often is responsible for stimulating high excitement and feelings of desire. You may think, “what about my friends who bought APPL stock back in the day? They made a killing! That could be me too right? I should buy Facebook stock. Or Twitter. Should I buy it today or wait until next week?” Obsession with alpha can be a costly distraction from the long-term financial goal. Yes, desire is more fun. Unfortunately, you can’t rationalize desire.

Illusion of Control Bias – “Believing one can control and influence the outcomes that one actually has no control over. (Langer 1975)”

According to Gus Sauter of the Vanguard Group, there are four key elements that affect your portfolio return. They are stock selection + market return + factor return + market timing. For the overwhelming majority of investors, including professionals, trying to control stock selection and market timing is really just an exercise in futility that is highly likely to leave you exhausted and ultimately disappointed. Focus on your long term goals and attempt to control only what will help you achieve them. We can help you get there.

Regret Aversion – “Avoiding an action for fear of making a poor choice (Humphrey 2004)”

You know this feeling. Delaying decision making is a natural instinct when making a tough choice. Anyone who has pressed the buy or sell button on their portfolio knows that cold feeling of hesitation. Should I buy now or wait for a correction? What if I am making a mistake? What if I lose money on this decision. What will my wife/husband think? I think I’ll wait until after the holidays to make up my mind… This fear of future regret can cause mental paralysis and keep us from making important decisions. As time is one of our greatest allies when it comes to investing, this is a cognitive bias that should not be left to simmer. The guidance of a professional investment advisor can help you get time back on your side.

Mental Accounting Bias – “Treating one sum of money differently than another equal-sized sum based on how the money is categorized. People mentally group their assets into non-interchangable mental accounts, when in reality money is inherently interchangeable (Thaler 1980)”

Looking at a top down view of your entire investment picture is often illuminating. Do I really have 75% of my assets in my real estate properties? I didn’t realize I was holding onto THAT much cash. I know my $200K in cash is stable and I know my $200K in equities will fluctuate daily, so how much do I have really? Quarterly performance reports on all of your assets, regardless of where they are held, is something you should get from your financial advisor. At Osbon Capital we consider this to be the standard.

Herding Bias – “Trading on the same side of the market in the same securities, ignoring conflicting information in favor of acting as other investors do, often for reassurance and comfort. (Grinblatt 1995)”

Exchange Traded Funds (ETFs) are in many ways similar to their older generation, the mutual fund. They both hold baskets of stocks and provide investors with a broad diversified exposure to a particular market. However, ETFs have expenses as low as just 1/10th (or less) of the cost of the average mutual fund and are significantly more tax efficient for individual investors. So why haven’t all investors made the jump to the ETF world? Herd mentality is a big part of the answer. Mutual funds and their partners, such as JPMorgan, Morgan Stanley, or UBS, have enormous advertising budgets. When most people own mutual funds, which is still the case, making the switch feels more difficult and risky than it really is. This herding bias keeps investors from the logical conclusion that the average ETF will simply outperform the average mutual fund by a factor of their respective costs.

Get back in 1st place
If you already know these biases, you’re ahead of 99% of investors out there. If you’re just discovering them now, you will find a powerful roadmap for the tough decisions you will inevitably face as an investor. Click here to request the full list of SSGA’s 28 cognitive investing biases. We can help you navigate these traps. We’d like to hear what you think.

Max Osbon – mosbon@osboncapital.com

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