10 cognitive biases that can lead to investment mistakes

As we move ahead in this information era, it’s more and more important for investors to understand the unconscious drivers that affect the way we make decisions about the money.

We start by looking at how our senses often mislead us into thinking that things are going on out there when they’re only going on in our heads. Our brains are adapted to the world around us, and they function in a way that gives us the best chance of survival, but these behaviors are often not appropriate when we are investing. Believing that we can predict markets in a desperate attempt to keep our brains pleased.

We believe it is essential to understand that we need to overcome common human cognitive or psychological biases to be a successful investor over the long term since these biases often lead to inferior decisions and investment mistakes. 

Cognitive biases are a common human tendency and we all tend to take shortcuts, be overconfident in our decision-making process. We need to understand cognitive biases to make better decisions which will eventually lower the risk and improve investment returns over time. Below are 10 cognitive biases that can lead to investment mistakes.

1. Confirmation bias

It is the natural human tendency to seek the information that confirms an existing opinion, conclusion, or hypothesis. Confirmation bias is a major reason for common investment mistakes as investors are often overconfident as they keep obtaining information that seems to confirm or support the decisions they have made. This overconfidence can result in a false sense that nothing will go wrong, which actually increases the risk of being unprepared when something does go wrong.

In particular, we can generate imaginary patterns using personal investing experiences. We start imagining that we can see trends where none really exist. Visual illusions are a type of imaginary pattern, so we can’t entirely trust our instincts. Many investors detect imaginary patterns & develop behavior that looks a lot like superstition because people are surprisingly getting inclined to bring them luck. Most of the time it is not that damaging, but when these superstitions start overriding rational investment decisions they can lead us into the serious money-losing territory. 

To minimize the risk of confirmation bias, we should continually reevaluate our investment decisions and question our assumptions with facts.

2. Anchoring bias or Recency Bias

Anchoring is the tendency to base our thoughts and beliefs on a piece of recent specific information that may have little or nothing to do with the situation at hand. 

Investors are generally biased by recent information, by recency, but recent events are often not a good basis for making long-term investment decisions. Our investment decisions should be considering long-term investment scenarios & not with short-term market events.

From an investment perspective, one obvious anchor is the recent trends on that asset. Tim Richards writes in his book, "Recency is particularly implicated in a range of investor misbehaviors because we tend to overweight the importance of the most recent events and to downplay more distant ones. This can have some strange and counterintuitive results, including the so-called gambler’s fallacy. Mostly, markets are also random, so a few days of a stock going up or down is likely to have no cause whatsoever, but recency effects such as the gambler’s fallacy seem to bias some people into expecting a change of direction. However, others will develop exactly the opposite hypothesis and assume that a particular sequence will carry on, presumably forever". People usually base their decisions on current news on television and newspaper but we should actually base our investment decisions on whether or not the price is cheaper than its actual value. The information shown in news can be tempting but the data should be studied over the lifetime of that asset before taking an investment decision.

3. Loss aversion effect

Loss aversion is the tendency of people who greatly prefer avoiding losses than thinking about obtaining gains. The loss-aversion tendency makes you break one of the important rules of economics; the measurement of 'opportunity cost'. We cannot avoid great investment opportunities because we have fear of potential losses.

If you want to be a successful investor, you must be able to properly measure opportunity cost & risk associated with it. We should not justify wrong past investment decisions due to our tendency to avoid losses. Investors who become anchored due to loss aversion will pass on great investment opportunities to retain existing loss-making investments in the hope of avoiding their losses.

A decision to keep or sell an existing investment must be calculated against its opportunity cost and risk involved in it.

4. Incentive-caused bias

Here we can see the power that rewards and incentives can have on human behavior, often leading to folly. Mostly every investment opportunity may have incentives in place to encourage people to participate. 

Buffett wrote in his 2000 shareholder letter that “Nothing sedates rationality like large doses of effortless money". 

We should evaluate the incentives and rewards systems in place to assess whether or not they are likely to benefit us to make rational long-term sustainable investment decisions. 

5. Oversimplification tendency

Many times people want clear and simple explanations to understand complex matters. Some matters are inherently complex or uncertain and cannot owe simple explanations. Common investment mistakes are made when people try to oversimplify complex matters.

Albert Einstein once said, “Make things as simple as possible, but no more simple. Staying within your ‘circle of competence is a key to successful investing. 

Buffet writes in his 1996 shareholder letter, "What an investor need is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence".

We have to accept the fact that investing is complex and we should be disciplined to try to ensure we do not overly simplify the inherent complexity of it.

If we cannot understand the complexity of an investment asset, we simply should not invest, no matter how compelling the ‘simplified’ investment case may appear. 

6. Hindsight bias

Hindsight bias is a tendency to conveniently see beneficial past events as predictable and bad events as not predictable. Hindsight bias may cause misshaping of memories of what was known or believed before an event occurred, and is a significant origin of overconfidence regarding an individual's ability to predict the outcomes of future events.

We generally read many explanations for inferior investment performance that blame the unpredictability and volatility of the markets. But not all investments can be attributed to an unpredictable event or market volatility but rather to errors of judgment. 

Hindsight bias is a dangerous state of mind as it clouds your neutrality in assessing past investment decisions and hinders your ability to learn from past mistakes. To reduce hindsight bias, we should spend significant time studying the investment decision based on facts.

7. Restraint bias

Restraint bias is the tendency to overestimate one’s ability to show restraint or level of control in the face of temptation or our impulsive behaviors.

For many people, money is the greatest temptation. The issue for many investors is how much they should invest in an asset when they believe they have identified a ‘sure winner’. Many investors stick to their 'best investment ideas' but those may not be best for everyone.

To overcome our natural tendency to buy more and more of our best ideas, we should assess the risk involved in it and diversify our portfolio with combinations of investment assets that may minimize the risk. 

8. Herd mentality or Bandwagon effect

The Herd mentality or bandwagon effect describes attaining comfort in something because many other people believe the same. 

To be a successful investor, you must be able to analyze and think individually & independently. Speculative projections are typically the result of herd mentality. We should not find comfort in what other people are doing or thinking related to a particular investment asset. We should always assess what is beneficial for us with respect to our financial goals and risk appetite.

9. Ignorance  bias

Humans tend to over or underestimate probability in decision-making. Most of the time we conveniently ignore the inconvenient facts. Most people are inclined to oversimplify and assume a single-point estimate when making investment decisions. 

The error investors make is to over or underestimate the risk of probable events. There is always a probability that ‘black swan’ events will happen but overcompensating every probable event can be costly for investors. We should seek to mitigate the risk of ‘black swan’ events by diversifying our investment portfolio. The issue for investors is panicking when the probability of such an event is usually correlated with the amount of press or market coverage on a particular event. 

Buffett once said: “The worst mistake you can make in stocks is to buy or sell stocks based on current headlines.”

10. Overconfidence bias

Overconfidence bias is a puzzling limitation of our mind, our excessive confidence in what we believe we know, and our apparent inability to realize the full extent of our ignorance and the uncertainty of the world we live in. We are inclined to overestimate how much we understand the world and to underestimate the role of probability in events. Overconfidence is fed by the imaginary inevitability of hindsight. 

Humbleness is very important in investing and a great way to help mitigate the effects of overconfidence bias. Individuals should be objective when evaluating their past investments in order to understand which event, the decision gave them success and which not.

It is important to remember that the movements of markets are not in our control and we should not attempt to create imaginary methods to predict them. Embrace uncertainty: it’s always there, it’s just that we don’t always accept it or realize it. Remember that the best investors tend to sit on their hands & do nothing when uncertainty is high. Most investors are mindless while investing. We need to be mindful & focused on our financial goals & Retirement planning. We should not hesitate to take advice from Financial experts or advisors if we have some doubts but making investment decisions with keeping bias in mind will always lead to the wrong investment decision.