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Your Brain: Friend or Foe?
What Every Investor Must Know About How Your Brain Can Actually Work Against You.
Whichever way you may look at it, when you’re wrong, you’re wrong. It’s a cruel reality that many investors have a hard time admitting, and even more have a hard time moving on from. Your brain, according to some social psychologists, ought to shoulder the blame for this burden. Cognitive biases plague every investor, but perhaps a better understanding of these 10 biases may save you from the next investing blunder you would’ve otherwise committed.
What exactly is a cognitive bias? A cognitive bias is “a pattern of deviation in judgment that occurs in particular situations, leading to perceptual distortion, inaccurate judgment, illogical interpretation, or what is broadly called “irrationality.”’ The mere fact that we as humans have developed cognitive biases signifies evolved thinking – and signifies a complex brain that is actively working to exploit a heuristic experience-based technique for problem solving and discovery. But sometimes those heuristics are wrong – and in the world of investing, these biases can lead our financial portfolios astray. Below are the ten cognitive biases that have the ability to sink your portfolio:
#1 of 10: Confirmation Bias
A confirmation bias is something we all can admit to: we like to be around others who agree with us. This can be true in the political world or when arguing about the greatest basketball player of all time. (It’s Jordan, not Bird.) Your argument is right, and becomes increasingly stronger when flanked by others who agree and do not challenge you.
#2 of 10: In-Group Bias
In that same vain, in-group bias means you tend to favor those in your immediate community. It may result from the urge to strengthen those bonds, or because you would hope those in your community would do the same for you—whatever the reason, it results in you overestimating the abilities of those in your community.
#3 of 10: Gambler’s Fallacy
The gambler’s fallacy may leave you broke, or worse, betting your home on the roulette table at 2 am at the Bellagio. It’s the belief that your luck will turn after so much poor luck, or that the latest hot streak you’ve had—finding a stray $20 on the street, another stray $20 in your jacket pocket—must continue so you purchase a lottery ticket. In reality, none of these events are related, and all are the result of happenstance. Your brain has merely created a narrative that connects them and seeks to deduce larger meaning from what is in actuality statistical noise.
#4 of 10: Neglecting Probability
If you’ve ever gulped out of anxiety as the plane prepares for liftoff on your latest work trip, there’s a good chance you’re neglecting probability. It is true: you’re much more likely to meet your end in a car accident than a plane crash, so breathe easy, and indulge yourself with a second bag of those free peanuts.
#5 of 10: Observational Selection Bias
Observational selection bias occurs when, after taking your bike to work one Monday morning, you notice that there are many more bicyclists on the road than before. Bicyclists are everywhere, you think, and the paranoia you feel is foolishness: there were just as many two-wheeled commuters before that Monday than after, now you’re just acknowledging them.
#6 of 10: Status-Quo Bias
The status-quo bias is yet another cognitive bias. We don’t like change, we like routines, we find comfort in a kind of stasis, and we perceive a change in our equilibrium to somehow be a “loss,” even if it actually beneficial. When you’re favorite route to work is blocked due to construction and you’re forced to take a different path – even if that different path takes you to work four minutes quicker (!!) – you can thank the status-quo bias for your resulting (and factually unjustified) frustration.
#7 of 10: Negativity Bias
On September 29 2008 the Dow lost 777 points and the headlines read loud and clear: “Dow Suffers Worst Day in History.” Attention grabbing, yet the day barely cracked the list of worst 15 days on a percentage basis. More interesting is that when the index regained 485 points the following day there were few headlines which read “Dow Enjoys Best Day in History,” although that was also true. (2nd best by 3 points at the time, to be fair). This is the result of negativity bias—the phenomena that people tend to pay more attention to negative news than good news. Be warned, this is a bias where the media is of course well aware.
#8 of 10: Bandwagon Effect
The bandwagon effect occurs when you wish to conform to the majority opinion. A prime example is the way you, and everyone else, believes that internet stocks of the 90’s can go up forever and ever despite having no earnings. It feels true, and it is comforting knowing you are with the masses.
#9 of 10: Projection Bias
And because you’re you, and nobody but you, you’re armed with a projection bias. You tend to assume others are just like you, think like you and draw conclusions in the same way as you do. And while you may not actually put words in other people’s mouths, you tend to think you understand the thought processes that cause those particular words to come out of their mouths. Wrapping your head around the fact that others all think in their own, unique ways is strangely hard.
#10 of 10: Anchoring Effect
And while every investor loves discovering a great deal, before you leap for the 60% OFF – FINAL MARKDOWN – EVERYTHING MUST GO hard-to-find item that you think will make your wife forgive you for that stupid argument you got into last night, think about the total cost, not the savings. The anchoring effect leads you to believe that the savings is what makes the purchase worth it, whereas it should be a combination of price, necessity, and more logical reasons that make it a worthwhile purchase.
So, to beat your brain at its own game, keep these 10 biases in your head—or in your gut. Next time you fall into one of these traps, you can only blame yourself. Or you can convince yourself that you were right all along.