It is interesting to think about the way we think. Humans are constantly processing new information and forming conclusions believed to be true. For investors, the validity of these conclusions makes the difference between profit and loss. So it is important to be aware of the tricks that your mind plays on you. And it is important to have a process in place to minimize the negative effects of these biases.
A New York Times article by Gary Belsky caught our eye some months ago titled: “Why We Think We’re Better Investors Than We Are.” It discusses a handful of cognitive biases that influence investors and can distort judgment. For example, it turns out that humans are overconfident, on average. Overconfidence refers to the difference between an individual’s perceived accuracy and their true accuracy, as we have discussed previously (here). As Belsky writes:
“Studies have revealed significant overconfidence in the judgments of scientists, lawyers, engineers, doctors and those in other professions. The University of Pennsylvania psychologists Philip Tetlock and Barbara Mellers collected more than 25,000 forecasts from people whose job it was to anticipate how the future would unfold. All demonstrated remarkable overconfidence. When they were 80 percent sure of their predictions, they were correct less than 60 percent of the time.”
Being aware of this bias is important for investors. As conviction in your next idea builds, just remember that your mind is likely building more conviction than is truly warranted.
Consider Optimism Bias – a mindset that truly permeates Wall Street. Humans are generally wired to be more optimistic about their own abilities than is perhaps fair. Far more investors believe they can outperform the market than truly can, for example. Belsky writes:
“A bias toward optimism helps to explain why many, if not most, smokers are confident that they will not develop cancer.”
Then there is Hindsight Bias – the tendency to rewrite our own history to make ourselves look good. Investors notoriously remember their winning investments and seem to delete their losers from memory. Or Attribution Bias which allows us to maintain faith in our own abilities – even in the face of contradictory evidence. As Belsky writes:
“When events unfold that confirm our thoughts or deeds, we attribute that happy outcome to our skills, knowledge or intuition. But when life proves our actions or beliefs to have been wrong, we blame outside causes over which we had no control.”
Finally, there is Confirmation Bias – perhaps the most dangerous of all to investors. You see, confirmation bias leads us to give too much weight to information that supports existing beliefs and discount that which does not. While this cognitive bias helps us feel good about the conclusions we believe to be true, it is not particularly helpful in identifying which conclusions are actually true.
Being aware of biases such as these is an important first step for investors. The next step is to then design a systematic investment process that mitigates the influence these biases can have on investment decisions.