What are cognitive errors?

Cognitive errors stem from the normal workings of the human brain. Our brains have limited computing power, so we rely on mental shortcuts and rules of thumb to quickly make sense of complex information. The problem is these shortcuts sometimes cause us to draw flawed conclusions which can lead to premature financial decisions.

Two major types of cognitive errors are belief perseverance biases and information processing biases. Belief perseverance biases cause us to cling to existing beliefs even when faced with new information that contradicts them. Information processing biases influence how we interpret and use information when making investment choices.

Overcoming confirmation bias

Another common cognitive error is confirmation bias. When it comes to investing, this can occur when you selectively search for and favour information that confirms your existing beliefs and opinions about an investment. For example, let’s say you believe tech stocks are poised for growth. Whenever you come across an article discussing the upside of tech stocks, you’re likely to think “Aha! This supports my belief that tech is the place to invest right now.” Articles discussing possible issues facing tech stocks might not register with you as strongly.

Some ways to potentially overcome confirmation bias:

• Actively seek out dissenting views that challenge your investment beliefs. Don’t just consume media aligned with your existing opinions.
• Question your assumptions and beliefs regarding investments. Ask yourself “What information might contradict this belief?” Then go out and look for evidence that contradicts you.
• Seek professional and credible advice, combine the knowledge with investment decision journals recording both the evidence supporting and contradicting a potential investment. Review this before finalising investment choices.

Anchoring adjustment bias

Another common information processing bias is anchoring adjustment bias. This occurs when you anchor to, or focus too heavily on the first piece of information you receive regarding an investment, hindering your ability to appropriately adjust as new information becomes available.

For example, right before purchasing shares of Company X stock trading at $50 per share, you hear an influential investor predict the stock may rise to $80 per share over the next year. You anchor to that first prediction of $80 per share in determining the value of Company X stock. Over the next few weeks, more conservative analyses are released predicting a price of only $60 per share. But you don’t sufficiently adjust downward from your original anchor point of $80, still believing that’s the likely price.

Some suggestions that could help with anchoring adjustment bias:

• Actively search for multiple views and forecasts when contemplating an investment rather than overly relying on just one
• When new information arises be sure to consciously reevaluate the insight relative to previous data points without favouring the first piece of data you encountered

What are emotional biases?

Ways to possibly avoid loss aversion bias

A very common emotional bias is loss aversion. Research shows that losing money is psychologically twice as powerful as gaining money. In other words, the joy of gaining $100 is only about half the pain of losing $100. This bias can cause many investors to hold onto losing stocks longer than they should, in hopes to at least break even, rather than cutting their losses.

A few practices that could assist to combat loss aversion bias:

• Set clear loss limits on investments and stick to them. For example, “If this stock declines to 8% below my purchase price, I will sell.”
• When determining sell points, calculate expected returns necessary to offset prior losses. This can allow for a decision to focus on potential future gains rather than prior regret over losses already locked in.

View your overall investment portfolio results periodically rather than daily stock losses/gains so short-term dips don’t overly influence sell decisions

Overconfidence bias

Many investors can lean towards overestimating their ability to pick winning stocks or time markets successfully. This overconfidence may cause them to trade more aggressively than appropriate. Emotionally, overconfident investors feel their strong convictions in their investment opinions justify frequent trading. But numerous studies show more trading can lead to lower investment returns over time.

Tips that may increase the likelihood to tackle overconfidence bias:

• Track your investment decisions and create an investing scorecard – benchmarking returns against standard market indexes. If underperforming regularly, consider scaling back trading activity.
• Look into investing primarily in low-fee, broad market index funds – this can help minimise the urge to frequently pick and choose individual stocks without adequate backing.

Be aware of your possible biases

Our behavioural biases often feel perfectly rational in the moment. But simply being aware of their existence can help us pause and consider alternate perspectives when contemplating financial decisions. Seeking opposing credible views, tracking investments methodically, and leaning on rules and limits can help counteract our native intuition in order to invest successfully over the long-term. Monitoring both cognitive errors and emotional biases takes discipline but can pay in dividends.