Don’t Make a Bad Investment in Cognitive Bias

Investing
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By Jeremy Office

Learn more about Jeremy on NerdWallet’s Ask an Advisor

The human brain can process 1016 operations per second. This makes our brains more powerful than any computer. So we should all be walking, talking savants and extraordinary investors.

Calculating equations in seconds, becoming multilingual encyclopedias who consistently make logical decisions — well, we all know that is not the case. Why aren’t we always logical? Thank you, cognitive bias!

Cognitive bias is a “pattern of deviation in judgment, whereby inferences about other people and situations may be drawn in an illogical fashion,” according to Wikipedia. These biases can derive from mental noise, emotional motivations and social influence.

Have you ever rejected evidence that contradicts your point of view, even when you know that evidence is true? That’s the “backfire effect” bias. Ever fallen victim to groupthink? That’s the “bandwagon effect” bias. Perhaps you think you’re smarter or more informed than the average person. Hello, “curse of knowledge” bias.

These biases cloud our ever-processing brains and can lead us to make the wrong investment choices, sometimes based on flawed emotional decisions. Here are a few more examples of biases. I want you to think: Have I done this? Have I felt this way?

Hindsight bias

“I knew random stock X would make a run for it this quarter. I knew it all along.” Of course you say this at the end of the quarter. When you have hindsight bias, you see past events as predictable. It is the classic Monday morning quarterback situation. Investors can get so caught up in hindsight that they lose sight of the bigger picture. It is easy to predict something — after it has happened.

Your action plan: Instead of focusing on what could have been, focus on your goals. Do you have a plan to reach your larger life goals? Keep striving to see the forest through the trees.

Irrational escalation

Have you bought a stock that was a real dog? You have to make a decision: Do I cut my losses? The irrational escalation bias says: No! Invest more money in the stock — even if you know it’s a bad one. You justify the increased investment in a decision based on the prior investment, despite new evidence that suggests the cost of continuing the decision outweighs the expected returns. You are throwing good money after bad.

Your action plan: Be rational. It’s OK to pick a bad stock; it’s not OK to let ego get in the way and keep yourself wedded to a losing position.

Overconfidence

Who needs an advisor? I can do this on my own — along with my full-time job, spending time with family, my hobbies, exercise activities and more. Keep in mind that professional fund managers, who have access to the best investment reports and computational models, often struggle to beat the market. And that is their full-time job! We are too confident about our abilities, and this causes us to take greater risks in our lives. How can you really do your full-time job, manage your household and be on top of all that is going on in the market?

Your action plan: Seek professional guidance. Information overload can fuel overconfidence, giving you a false sense of knowledge and security. You trust your doctor with you health; you need to trust your advisor with your finances. Focus on what you do best, and leave the rest to the experts.

These are just a few of the ways biases can affect your judgment and your investments. Understanding that biases exist can give you a fresh perspective and the tools to succeed.