My last post outlined Barry Ritholtz’s 10
investor mistakes and then provided some solutions. In this post, I will focus on cognitive
errors investors make.
I recently read an article entitled “Investors’
10 Most Common Behavioral Biases” by Robert Seawright. I really think behavioral finance aspects of
investing are vastly overlooked, especially when it comes to Modern Portfolio
Theory and a total set it and forget it
allocation. Below, I summarize the
list and suggest possible ways to correct such biases:
- Confirmation Bias – get to the conclusion first and then find facts to support it. Solution: Seek out information that runs contrary to your current opinions and conclusions.
- Optimism Bias – you believe you are less at risk of experiencing a negative than everyone else. Solution: Focus on the capital you have at risk.
- Loss Aversion – losses feel much worse than gains feel good leading to poor investment decisions (note: this conflicts with number 2 and as the author states “we tend to make bold forecasts but timid choices”). Solution: Have a plan in place in the event you start to experience losses.
- Self-Serving Bias – good things happen because of you, bad things are someone else’s fault. Solution: Be humble regarding gains, owe a part of it to dumb luck, have a plan on the way down so losses are in your hands.
- The Planning Fallacy – we overrate our own abilities, underestimate the process, and overestimate the gains. Solution: Have an objective look at the risk/return profile of your investments, realize the future won’t replicate the past, and be cognizant of hedging costs.
- Choice Paralysis – too many choices lead to decision paralysis. Solution: Reduce the number of your investment holdings and focus on asset class over managers.
- Herding – herd behavior. Solution: Be cognizant of the herd, but don’t follow it without a logical reason. Realize investment managers also follow herd behavior (e.g. they get hammered less if they are wrong when everyone else is, but are hammered harder if they are wrong when the herd is right).
- We Prefer Stories to Analysis – people tend to prefer a narrative to data: it’s easier to understand. Solution: Analyze data, look for trends, and make objective decisions based facts, not stories.
- Recency Bias – extrapolate recent events into the future indefinitely. Solution: Filter noise and look for signals. Generally, ignore most analysts.
- The Bias-Blind Spot – not recognizing we have cognitive deficiencies. Solution: Read the attached article and this blog post.
Next up, my own
additions to the last two posts.
