Last week in Part 2, we examined the remaining emotional biases as well as introduced social biases that many are prone to. This week we’ll cover cognitive factors that often affect investors and wrap up the discussion with helpful tips.
Biases Based on Cognitive Factors
Over the course of our lives, we develop cognitive preconceptions, which we learn from our past experiences – but they can also be tricky. Cognitive biases result from the mind’s limited capacity to process complex information without historical consideration. Normally a great skill, this thought pattern doesn’t work well when dealing with investments because past performance is not indicative of future behavior. Some cognitive biases that lead to flawed financial thinking include:
- Representative heuristic (or mental shortcuts) is the inclination to categorize a situation based on a pattern of your previous experiences. For example, if a certain company’s stock performed very well in the past, you think this is represents how well the stock will perform in the future. As a result, you purchase the stock without considering how trends in stocks change over time.
- Confirmation bias is the tendency to absorb only facts you agree with and block out information that challenges your belief. For example, if you have an original idea about an investment, you may only seek out information that supports your original supposition, while avoiding facts that contradict your belief.
- Framing bias is the propensity to react differently to the same information, depending on how it is presented to you. When there are many unknown factors, you can be more vulnerable to framing because you have no data to rely on. An example would be taking investment actions based on how well dressed the company’s CFO is, a factor unrelated to how well the stock will actually perform.
- Gamblers fallacy happens when you misinterpret the law of averages. We erroneously believe that a run in a particular type of random process makes a reversion more likely. This misjudgment also applies to investors who sell a stock that has consistently gone up because they feel it’s unlikely the stock will continue to rise.
In closing, it’s important to remember that biases can clutter your financial thinking and prevent you from making sound investment decisions. These biases might also lead you to under-diversify your portfolio, fail to rebalance your portfolio, chase performance, trade too frequently or too infrequently, or pay more in taxes and commissions.
Biases based on emotions take more work to fix because they stem from instinctive or involuntary reactions. Preconceptions based on cognitive and social factors are more easily addressed through education. Nevertheless, we are here to help you reduce the role biases play in your financial thinking by:
- Identify your investment objectives
- Develop a sound methodology for your investments and stick to it
- Diversify your investments
- Regularly rebalance
Finally, at Arista CB Wealth Management, we rely on prudent, academically sound financial planning. Again, we want to help you avoid making mistakes. If you have any questions, please call or email our office to schedule an appointment. I hope this series has been beneficial to understanding bias in your financial thinking.
*Bruce Miller is an Investment Adviser Representative of Arista Wealth Management, LLC, a Registered Investment Adviser
Bruce Miller condensed this article originally produced by Advicent Solutions, an entity unrelated to Arista Wealth Management. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Arista Wealth does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues.
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