Be Mindful of Your Cognitive Biases

We all use mental heuristics to simplify complex information. It allows us to make more efficient decisions.

Cognitive biases can have a detrimental impact on our investments. Recognizing these biases, however, can mitigate the risk of making a bad decision.

In this week’s webcast, we’re joined by psychologist Dr. Jack Muskat, an expert on this topic.

Here are 3 examples of a cognitive bias that affect many investors.

Anchoring

Anchoring happens whenever an individual relies too heavily on previous information. Often, investors will anchor the price paid for a stock. More often than not, if the stock price drops immediately after a person buys it, many will hope and pray for it to reclaim the price that they previously paid. If it happens, many sell the position right away. However, this approach ignores the true value of a company. If a company’s future prospects change, so too should its stock price.

Overconfidence

Investors often overestimate their knowledge and ability to predict future events. This can lead to excessive trading, purchasing high risk investments, and underestimating future losses. Overconfidence can cause someone to have an inappropriate asset allocation or own stocks with characteristics that are inconsistent with that person’s own risk profile.

Herd Mentality

Many follow the crowd. This means buying the stocks going up and selling the stocks going down. This strategy can lead an investor to buy into a market bubble or sell into a market downturn.

To mitigate against cognitive biases, Schneider & Pollock employs several strategies.

1. Prior to buying or selling any stock, we record the pros and cons of a company and its stock on paper. Recording your information in writing forces you to think about the risks and uncertainties that many people overlook.
2. We summarize our investment thesis into 3-5 sentences. Each time new information shows up in a news release or media report, we compare the information against our investment thesis. John Keynes once said, “when the facts change, I change.”
3. It’s a good idea to regularly review your investment with a fresh set of eyes. Quarterly earnings releases, coupled with the management conference call, is a great resource. We recreate our pros and cons research each quarter for all 25 stocks that our clients own.

While cognitive biases are an inherent part of everyone’s decision-making, their impacts can be mitigated with awareness. Investing is as much about managing psychological factors as it is about analyzing complex financial data.