In the first part of this article, we introduced some cognitive errors that affect our investment results. Here is the second part of these mistakes, before moving into the emotional aspects that influence us as investors.
- Illusion of Control Bias: When people tend to believe that they can control or influence outcomes when they cannot.
Example: When I buy a stock, I expect it to go up because I did. Truth is, I have no influence in the market as a price-taker.
Consequences: Trade more than is prudent since investors tend to believe they have control over the investments results; lead investors to inadequately diversify portfolios.
Hindsight bias: Having selective perception and retention aspects. See past events as having been predictable and reasonable to expect. This behavior is based on the obvious fact that outcomes that did occur are more readily evident than outcomes that did not occur.
Example: Detecting a “clear” entry point after a stock has already rebounded, or stating that a crash was evident once it has already occurred.
Consequences: Overestimate the degree to which an investment outcome can be predicted and a having a false sense of confidence; assess money managers or performance incorrectly.
- Anchoring and adjustment bias: When the use of a psychological rule-of-thumb influences the way people estimate probabilities. When facing values with unknown magnitudes, we usually envision an initial default number.
Example: When a stock is purchased at $20 and it falls to $10, we tend to believe that it should come back to $20 because that’s the anchor in our head.
Consequences: Sticking too closely with original estimates when new information is learned.
Mental accounting bias: Treating one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.
Example: This happens when in our head we have “betting” money, “conservative” money and so on. We treat money discriminately regardless of its fungibility.
Consequences: Placement of investments into discrete “buckets” without regard for the correlations among these assets; Neglect opportunities to reduce risk by combining assets with low correlations; irrationally distinguish between returns derived from income and those derived from capital appreciation.
- Framing bias: Answering a question differently based on the way in which it is asked.
Example: Which of these options sounds more attractive? A stock with a 30% chance of appreciating over 100% or a stock that could lose half its value in 7 out of 10 times? Or reacting more to penalties than prizes.
Consequences: Misidentify risk tolerances because of how questions were framed; choose suboptimal investments and focus or short-term price fluctuations.
Availability bias: Taking a rule-of-thumb to estimate the probability of an outcome based on how easily the outcome comes to mind. Comes from various sources:
- Retrievability: When the first idea we recall is assumed to be the correct one.
- Categorization: Perceive a different relevance for each data set.
- Narrow range of experience: Over/underestimate proportions
- Resonance: When we are biased by how closely a situation parallels their own personal situation.
Example: A combination of these could over-simplify a complex issue like oil prices and assume reversion to the mean just because that has happened before.
Consequences: Choose an investment based on advertising rather than on a thorough analysis of options; limit investment opportunity set; fail to diversify; fail to achieve an appropriate asset allocation.
Cognitive errors are statistical, information-processing, or memory errors that result in faulty reasoning and analysis. As investors, we might be willing to assume a rational path in our decision-making process but fail to achieve so when we encounter these errors. Documenting our decision process might help us detect and reduce our mistakes, and it is also vital to be honest with ourselves and form good habits.
"Chains of habit are too light to be felt until they are too heavy to be broken." Warren Buffett (Trades, Portfolio)
"The first principle is that you must not fool yourself- and you are the easiest person to fool." Richard Feynman
