How Recognizing Cognitive Biases Can Improve Your Investment Performance

Nov 16, 2022 | BDE, Be More, Do More, Earn More

“Nothing is so difficult as not deceiving oneself.”

Ludwig Wittgenstein, 20th century Austrian-British philosopher

There are many ways in which flawed thinking is hardwired into our brains. Wikipedia has compiled a collection of more than 150 cognitive biases. Some are related to our sense of self, like egocentric bias, in which we are prone to unjustifiably give more weight to our own perspective. Many other biases affect how we perceive the likelihood of events. A bias termed the gambler’s fallacy makes us think that the odds of a coin landing on heads are increased if it landed on tails the last 10 times it was flipped. It isn’t. The odds are always 50–50.

Cognitive biases often affect our financial decisions. Mix the heated emotions behind money with the complexity of investing, and you can have a psychological recipe for disaster.

One of the most common psychological traps when it comes to investing is called the overconfidence effect. This deep-seated mental bias can rear its ugly head when your investments are doing well and makes smart investing so difficult, even for wise and capable people.

When your investments are on an upswing, the overconfidence bias unconsciously leads you to attribute your gains to your own decision-making. Conversely, when your investment choices lead to losses, you are more likely to attribute the negative consequences to something else — poor investment advice or bad luck. Overwhelming research shows that even most professional money managers are likely to become overly optimistic in the belief that they can beat the market after they see high returns.

This very flawed thinking often ignores the most basic tenant of investing: buy low and sell high. Most investors learn an expensive lesson when they become overconfident and buy more stocks at an unnecessarily high price while missing a majority of the upward market momentum. They ignore diversification, make a concentrated bet with their wealth, and are often sorely disappointed when the risky gamble doesn’t pay off.

Many were hurt by the overconfidence effect in the mid-2000s. Between 2004 and 2007, international stocks saw double-digit percentage gains every year. Almost everyone would gain some confidence in their decision-making with these positive investments in their portfolio. If you allowed this hubris to sway your decision-making and poured more wealth into international stocks when they were hot, you’d be sorely disappointed when they lost more than forty percent of their value in 2008.

What can you do to protect yourself from the effect of cognitive biases on your investment decisions? If you look to the scholars who dedicate their careers to studying cognitive biases, you’ll find that they do not agree about whether humans can overcome these biases. In an article in The Atlantic, Ben Yagoda spoke with some of the preeminent professors in the field. The experts disagreed about whether we can eliminate our biases. Some think the biases are buried too deeply in our brains to be changed. On the other hand, the experts did agree that we can improve our behavior by being aware of biases we hold and analyzing our thinking process before we make a decision.

There are a few things you can do to combat your overconfidence bias and minimize its effect on your investment decisions. First, revisit your past performance. Looking back at times your investment decisions led to gains and the times they resulted in losses gives you a dose of reality. Second, you can consult independent data about the companies you’re considering investing in. Third, work with a professional investment advisor, especially one who can explain to you how their investment plan is disciplined and based upon solid research and long-term results.

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