Investing? Avoid these five cognitive biases

23 Oct 2018

Patrick Lawlor

Writer, Investec Wealth & Investment

We may think we make rational investment decisions, but the reality is that we are subject to emotions, and as such, are prone to biases that lead to systematic errors.

Understanding and responding to cognitive biases has become a much-studied field, called behavioural finance, which draws on behavioural psychology. Investors often end up reacting to events on an ad hoc basis, rather than making decisions based on a portfolio decision-making framework, leading to overly risky purchases or sales.
 
We tend to overemphasise information that is widely available. An idea or fact is not worth more merely because it is available to you.
While there is much literature on this topic, a good synopsis comes from legendary investor Charlie Munger, the vice-chairman of Berkshire Hathaway.
 
In 1995, Munger gave a speech to Harvard University students about 25 cognitive (or behavioural) biases that cause us to make misjudgements. This is a famous speech that is more than an hour long and can be watched on YouTube:
 

(See also the full list of biases at the end of this article.)

The Psychology of Human Misjudgement – Charlie Munger's full speech

(See also the full list of biases at the end of this article.)

 
It’s a must-watch video for anyone interested in the psychology of investment and in how, by being aware of our cognitive biases, we can avoid their pitfalls.
 
People hate to hear bad news or anything inconsistent with their existing, often deep-seated opinions or conclusions.
In this article, we won't examine all 25cognitive biases (the video explains them all very well). Rather, we will focus on five of them that relate, in particular, to our investment biases and misjudgements. 
 

Doubt-avoidance tendency

This bias is what happens when we are unsure of what to do. In these situations, we tend to make quick, ill-informed decisions to avoid all doubt. In situations of danger, this triggers our automatic fight-or-flight response. But in most of the situations in life, immediate decisions are not necessary. Some of the time, like during periods of physical danger, an automatic response is necessary. But most of the time, we don't need to make instant decisions and it becomes detrimental to our judgement. Certainly, when it comes to investing, avoiding doubt by making quick decisions is dangerous.
 
What is the solution to avoid this tendency? Think slowly. Take a breather. Sleep on it before making a decision. It's rare in the investment world that we need to make a knee-jerk decision.
 

Simple, pain-avoiding tendency

People hate to hear bad news or anything inconsistent with their existing, often deep-seated opinions or conclusions. Therefore, when new facts emerge that go against these, or when existing beliefs are challenged, the human brain often goes into a stage of denial to relieve the pain (what behaviourists sometimes refer to as 'cognitive dissonance'). An example is when projections are made about a certain company which do not happen and we go into a stage of denial. Another example is when our most loved share, or 'top pick', turns out to be in structural decline and we refuse to adjust to the facts, holding on to our losers instead of taking the pain and selling.
 
What is the solution to avoid this tendency? Always keep yourself open to changing your opinion should the facts change. Face reality hard on and learn to deal with the pain of being wrong.
 

Availability-misweighting tendency

We tend to overemphasise information that is widely available. An idea or fact is not worth more merely because it is available to you. An example is if you are bullish on oil, and you decide to buy JSE-listed Sasol rather than one of its international competitors. Or, if you like the luxury goods sector, should you be buying JSE-listed Richemont, or is Louis Vuitton a better bet? Buying Sasol or Richemont simply because they are more accessible to South African investors does not make them better investments than their competitors.
 
What is the solution to avoid this tendency? Brainstorm all possibilities rather than trying to jump to conclusions based on limited information. Use checklists to make sure you have covered all information, not just the information readily available.
 

'Twaddle' tendency

This one is best explained by Munger himself: “Man, as a social animal who has the gift of language, is born to prattle and to pour out twaddle that does much damage when serious work is being attempted. Some people produce copious amounts of twaddle and others very little.” There is a tendency for people to talk a lot about things that they’re not experts in.
 
The best solution to this problem is to say "I don’t know" or "I will find out the answer rather than sound like a know-it-all". This may not be great for your ego, but it will probably lead to better investment decisions and gain you a lot more respect over the longer term.
 

'Lollapalooza' effect

This tendency is when we get extreme consequences from confluences of psychological tendencies acting in favour of a particular outcome. When two or more of these psychological biases combine together, the effect gets compounded exponentially. An example in the stock market was during the global financial crisis, where a confluence of causes acted together to cause the meltdown in financial markets; or the IT bubble, where several psychological tendencies caused the rally and crash. The success of Tupperware parties, where a mixture of psychological tendencies is preyed upon, is another example of the Lollapalooza effect.
 
If we can identify how some of these tendencies affect our decision-making process, we can possibly then try to counteract them to produce better judgement calls, which will make us better investors.
 
Think slowly. Take a breather. Sleep on it before making a decision. It's rare in the investment world that we need to make a knee-jerk decision.

The full list of cognitive biases:

Bias 1  –  Reward and Punishment Super-Response Tendency
Bias 2  –  Liking/Loving Tendency
Bias 3  –  Disliking/Hating Tendency
Bias 4  –  Doubt-Avoidance Tendency
Bias 5  –  Inconsistency-Avoidance Tendency
Bias 6  –  Curiosity Tendency
Bias 7  –  Kantian Fairness Tendency
Bias 8  –  Envy/Jealousy Tendency
Bias 9  –  Reciprocation Tendency
Bias 10 –  Influence-From-Mere-Association Tendency
Bias 11 –  Simple, Pain-Avoiding Psychological Denial
Bias 12 –  Excessive Self-Regard Tendency
Bias 13 –  Over-Optimism Tendency
Bias 14 –  Deprival-Superreaction Tendency
Bias 15 –  Social-Proof Tendency
Bias 16 –  Contrast-Misreaction Tendency
Bias 17 –  Stress-Influence Tendency
Bias 18 –  Availability-Misweighing Tendency
Bias 19 –  Use-it-or-Lose-It Tendency
Bias 20 –  Drug-Misinfluence Tendency
Bias 21 –  Senescence-Misinfluence Tendency
Bias 22 –  Authority-Misinfluence Tendency
Bias 23 –  Twaddle Tendency
Bias 24 –  Reason – Respecting Tendency
Bias 25 –  Lollapalooza Tendency
 
See more information here: 25cognitivebiases.com

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