Cognitive biases are deeply ingrained in the human psyche, representing mental processes that have evolved as we mature to aid in swift decision-making and effective problem-solving. These mental shortcuts, known as heuristics, are pivotal in our daily reasoning and actions, optimising our responses in a complex and time-sensitive world.
However, while heuristics enhance efficiency in navigating our surroundings, they simultaneously introduce biases that can significantly influence our judgments and choices. The domain of investment decisions, in particular, is highly susceptible to the influence of these cognitive and emotional biases, potentially leading to suboptimal choices and financial losses. This article sheds light on five more cognitive biases that can influence our investment decision-making substantially.
Read Part 1 here.
1. Sunk cost fallacy
The sunk cost fallacy is a cognitive bias that manifests when individuals persist with a decision or endeavour based on the resources they’ve previously invested, even when it becomes evident that the investment is unlikely to yield desired outcomes. Individuals often succumb to this fallacy when they let their past investments disproportionately influence their future decisions, whether in terms of time, money, or effort. For instance, many investors hold on to a failing investment and even pour additional funds into it to average down, driven by the belief that they can recoup their initial investment. This irrational behaviour stems from a desire to avoid the emotional discomfort of admitting a loss and abandoning the investment. Recognising the sunk cost fallacy is essential for rational decisions, as past investments should not cloud the evaluation of present and prospects.
How to deal with it: To effectively counter the sunk cost fallacy, shifting the focus from the past investment to the current and future value of the decision is imperative. Evaluating potential gains and losses objectively at the current point in time and detaching emotionally from the resources previously invested is essential. Seeking input and discussion from impartial parties or implementing decision-making frameworks that prioritise current and future outcomes can aid in overcoming this fallacy. Investors should also consider cutting their losses when the data suggests it is prudent rather than letting past investments drive their decisions.
2. Hindsight bias
Hindsight bias, also better known as the ‘I-knew-it’ effect, is a psychological tendency wherein individuals believe after an event has occurred that the outcome was predictable or inevitable, even when there was limited foresight or predictive ability before the event occurred. Those affected by hindsight bias tend to perceive past events as more predictable than they were, inadvertently underestimating the uncertainty and complexity present at the time. This bias can hinder accurate assessment and learn from past experiences, distorting our memory and comprehension of the true factors and knowledge accessible before the event. For example, during the post-pandemic stock market surge, many investors believed they could foresee the rapid rise in tech stock prices – which eventually crashed in 2022.
How to deal with it: Mitigating hindsight bias involves consciously reminding oneself of the knowledge and circumstances present during a past event. Encouraging critical reflection on what was known or knowable before the event can help reduce the distortion of memory and perception. Additionally, maintaining a record of initial expectations and assumptions before an event can be a valuable tool to combat hindsight bias and improve decision-making processes.
3. Recency bias
Recency bias is a cognitive bias where individuals tend to lean heavily on recent events or experiences when making decisions. This bias places a disproportionate emphasis on recent information, significantly impacting their perception of current situations or trends. Unfortunately, it often leads investors to overlook newly available data while excessively fixating on immediate patterns. For instance, in 2021, many Malaysian investors hastily embraced glove stocks following a significant decline in stock prices within the industry. Their optimism rested on the expectation of stock prices reverting to the all-time highs observed in 2020 during a surge in demand for glove-related products during the pandemic. Unfortunately, this approach failed to account for the drastic decline in demand that materialised in 2021. This tendency to prioritise recent events over a broader context can lead to suboptimal decision-making and financial consequences.
How to deal with it: The influence of recency bias can be mitigated by consciously considering a broader range of information and looking at trend patterns for a longer duration. Investors should diligently review historical and newly available data, trends, and long-term performance instead of fixating solely on recent market movements. Implementing strategies to diversify information sources and seeking discussion with various individuals with different experiences can also assist in reducing the impact of recency bias on decision-making. Taking a step back to analyse the bigger picture and resisting the allure of short-term trends are vital for making more informed and balanced investment choices.
4. Endowment bias
Endowment bias is a cognitive phenomenon where individuals assign a higher value to something simply because they own or possess it. This subtle bias is deeply rooted in psychological attachment and the sense of ownership, leading people to overvalue what they already possess compared to what they don’t. For instance, an individual might ascribe a higher value to a stock they own and hesitate to sell, even when the market value is considerably overpriced.
How to deal with it: The initial step in mitigating the impact of endowment bias involves recognising and acknowledging its presence. Individuals can consciously work on separating the emotional attachment and perceived ownership from the true value of an item or investment, enabling them to make more rational judgments. Striving for a balanced evaluation of assets, considering factors beyond ownership, and objectively weighing options are essential strategies to counter the effects of endowment bias and make sound investment decisions.
5. Halo effect
The halo effect describes how our overall impression of a person, product, or brand can significantly influence our perceptions of their traits or qualities. This bias occurs when we form a positive impression of an individual or entity in one aspect, and this positive perception then extends to cloud our judgment of their abilities, actions, or attributes in unrelated areas. For instance, witnessing the success of ‘software as a service’ (SaaS) giants like Adobe and Microsoft has led many investors to automatically assign high price multiples to other emerging SaaS companies, assuming that they will eventually possess similar positive qualities such as recurring revenue and high gross margin, even in the absence of direct evidence.
How to deal with it: To mitigate the halo effect effectively, we must consciously separate our overall impression from the specific attributes or qualities we’re evaluating. Striving for an analytical and impartial assessment of each trait independently can help counter the influence of a positive or negative impression. Taking a step back, assessing information critically, and considering multiple perspectives can aid in making more rational and unbiased judgments, free from the undue influence of the halo effect.
The fifth perspective
Mastering the understanding and management of biases is essential for any investor seeking to enhance their decision-making acumen. It is vital to recognise these biases as inherent cognitive shortcuts that humans tend to rely on, potentially distorting our judgment. Deliberately slowing down the decision-making process and implementing structured decision-making frameworks can create vital spaces for critical evaluation, enabling individuals to counter judgments’ impulsive and biased nature.
Keeping a well-documented journal of thought processes during our decision-making is a reflective tool to dissect past choices, pinpoint recurring biases, and foster continuous self-improvement. Consistent repetition of these steps and the gradual development of proficiency over time will lay the groundwork for successfully navigating biases and making better investment decisions. While this ongoing journey demands dedication, discipline, and continuous self-awareness, the rewards of improved investment outcomes unquestionably justify the effort and commitment invested.