Knowing how your mind works can help you avoid the more obvious traps many investors fall into.
Cognitive bias has become a bit of an investing buzz phrase in recent years.
The theory is that the human brain predictably makes errors of judgment that can lead us to be emotional, short term and come to other incorrect conclusions.
Cognitive bias has been of particular interest to the investing community and long lists of biases – confirmation bias, anchoring, the recency effect and dozens of others – are now the stock-in-trade of beginner investors worldwide.
The Nobel-prize winning economist Daniel Kahneman first researched bias in human thinking, distinguishing two ways in which we think: an automatic, instinctive and almost involuntary style contrasted with effortful, considered and logical thought.
That original research has grown into an industry.
Researchers and psychologists have identified endless ways in which the human brain is prone to bias, errors and poor judgment – and the investing community has latched on.
But underlying it all is that original finding that we spontaneously seek an intuitive solution to our problems rather than taking a logical, methodical approach.
Kahneman wrote that when we are confronted with a problem – such as choosing the right chess move or selecting an investment – our desire for a quick, intuitive answer takes over.
Where we have the relevant expertise, this intuition can often be right. A chess master’s intuition when faced with a complicated game position is likely to be pretty good.
But when questions are complex and rely on incomplete information, like investing, our intuition fails us.
The very fact we find the concept of cognitive bias so appealing is simply another example of our innate desire for simple, intuitive answers.
Unfortunately, the world is complicated, and almost everything that happens in investment markets emerges from the combination of a web of unrelated, intricate and multi-faceted events.
Our bias towards simplicity is reinforced by the nightly news and the morning newspapers that persist in providing simple explanations for complex events. Each day, market movements are distilled into ‘this-caused-that’ explanations that obscure the true drivers of change.
It is our intuition that is reacting when we find ourselves excited that markets rose 100 points – and a little nervous when markets ‘wipe off’ billions. We experience these emotional reactions even though the effect on our overall wealth from either event is likely to be tiny.
Our understanding of history is similarly simple, reducing wars, recessions and pandemics into simple cause and effect stories that are easy to remember and teach.
These stories help us understand the past. But they do not help us predict the future.
This explains why investment opportunities that seemed certain at the time we made them so often go awry.
It is not bad luck or circumstances changing against us – it’s the fundamentally simplistic cause and effect model in our minds that doesn’t allow us to understand all the possible outcomes.
So how can we best use the science of cognitive bias to become better at investing?
It is certainly worth learning about the wide and growing range of cognitive biases scientists are identifying that can stand in your way of being more successful.
Knowing how your mind works can help you avoid the more obvious traps many investors fall into.
We can use the basic principles of successful investing to avoid becoming victim to our own cognitive biases. Stick to a plan and don’t react to market noise or your emotions. Stay diversified to reduce the risk of permanent loss. And ensure you do not spend too much money on unnecessary fees.
But it is also a trap to rely too heavily on the science of cognitive bias, thinking that it can provide you with the keys to investing success.
The serious research being done by psychologists has been co-opted to offer you yet another tempting short cut – and in successful investing, there is no such thing.
If you’d like to find out more about investing, contact us on (03) 9769 9500.
Source: Vanguard
Reproduced with permission of Vanguard Investments Australia Ltd
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