To be good at investing, you need to be knowledgeable about various topics and schools of thought. To be great at investing, you need to have psychic powers.
Well, not really psychic, but there are ways a little knowledge about psychology can come in handy.
Ever heard of cognitive bias? If not, then buckle up, because it’s affecting your investments in several different ways.
As an investing coach with lots of experience in the trenches, I’m going to tell you how certain ways of thinking harm how we make decisions in our everyday lives and when we invest.
What is Cognitive Bias?
At its most basic, cognitive bias is a kind of mindset that we form to help us make decisions. Biases mean we are more likely to make one choice over another for seemingly no real reason.
A cognitive bias can make us too afraid to make certain decisions. Qualified psychologists believe there are more than a hundred different kinds of cognitive bias.
Let’s look at a handful of them and how they may affect you and your investment strategies.
Types of Cognitive Bias
- Oversimplification Tendency – A stock may have great potential, but a number of factors may cause it to crash. When researching it, you may distill it down to only the better selling points in order to make it a more attractive opportunity.
- Loss aversion – If you are more scared of losing than the potential win, you may not be willing to take certain risks. You might choose not to buy certain stocks because the potential for loss seems too great compared to the win.
- Anchoring Bias – You might look at a stock’s history and convince yourself that, because the stock has done well in the past, it will continue to do well in the future. You ignore any current information and rely on the market remaining exactly as it had over the years prior.
- Confirmation Bias – While you do your research, you might selectively pick only evidence that supports your current belief in the stock and ignore anything that might contradict this.
- Sunk Cost Fallacy – If you invest a lot of money into one company, you may feel like you have to stick with it. The more you invest, the more you may feel compelled to stay with it.
How Cognitive Biases Affect Your Investments
We like to think we’re always trying to make the best decisions when it comes to our investment strategies (of course, this is also a bias. Tricky, no?). You often hear phrases like “trust your instincts” or “go with your gut feelings,” but these feelings are precisely what our biases create.
It may feel like a great idea to invest heavily in a company that has always done well in the past, but times and trends change. A company selling a specific brand of popular shoes in the 1990s may not stay as relevant into the 2030s.
Conversely, being overcautious or too afraid to lose also has the potential to make you miss out on the next big thing. After all, you miss 100% of the shots you never take.
There’s nothing wrong with aiming high, but you have to make sure you don’t blind yourself to the facts. When you look for patterns or evidence to back up your instincts, you will always find it. This often means you will ignore any warning signs that might stop you from investing in a company with no future.
Ways to Overcome Cognitive Bias
1. Be Aware of your Biases
First and foremost, you must always remember you are human. Humans make mistakes, and no one is perfect. This may sound cliché, but it’s the best starting point.
Because it is true.
If you find yourself looking at a stock or some other investment opportunity and instinctively buying into it, stop and ask yourself why you feel you need to. If you can’t come up with a good reason right away, you will know it is based on a bias, and from there, you can start to consider the purchase.
2. Do Your Research
If you feel that you should invest in a specific stock, the next step should be to research it thoroughly.
First, gather all the information you would normally feel is right. Then start looking for information that contradicts what you have found. It always pays to actively find evidence that goes against what you want to believe so that you can get a more balanced view of what you stand to gain.
Make sure you address everything and don’t omit anything that might seem like too much of a deal-breaker. If this information exists, you may indeed be staring at a dud, and you don’t want to convince yourself otherwise.
3. Set Rules
If you give yourself specific time limits on how long you hold a stock before selling, then you may find you sail through any market lows. You may want to bail at the first sign of trouble, but this will often be more detrimental in the long run.
Some people tell themselves they will hold each stock for a minimum of six months or a year before they entertain the idea of selling. This way, they get a better feel for how the market is doing, rather than jumping ship prematurely.
4. Don’t Hold on Too Long
If you have put a lot of money into a certain instrument you want to succeed but haven’t seen any growth in it for several months, it may be time to cut and run. You may feel like you have to stick with a stock if you put a lot into it, but if there has been no sign of improvement, you have to know to cut your losses. That’s financial investing 101.
It sucks to take a loss, but it’s always better to lose out a little in the short run rather than leave a bad situation to get worse.
Over to You
Cognitive biases are tricky things, and often, attempting to overcome one will lead you to another. This does not mean that it’s a hopeless cause, though.
So long as you keep yourself aware, take a step back, give equal credence to pros and cons, and seek help and advice whenever things get rough, you can and will find ways to overcome these biases.