Cognitive & Emotional Investing Biases

Love him or hate him, Carl Jung’s influence on psychology and philosophy is mirrored in modern thought, and his work casts a shadow over society’s understanding of the self. If Jung himself were reading that sentence, he’d probably point out the role of the subconscious in expressing his influence using the ideas of “mirrors” and “shadows,” which he would often use as metaphors in his work. And who knows if he would be right, because as with most subconscious tendencies, it’s difficult and uncomfortable work to gain the high-level awareness that is required to check our own subliminal thoughts. But according to Jung, this self-investigation is well worth it. Jung is quoted saying, “Until you make the unconscious conscious, it will direct your life and you will call it fate,” promising that ignorance is actually not the bliss that some think it is. As challenging as it is to take an honest look in the mirror or turn and confront our own shadow, ultimately this courageous act of self-awareness can be a transformative agent of positive change. And one area where it’s been proven that unconscious biases are directly affecting people’s lives is in their investing strategies. Dalbar is a research firm that explores investor behavior, and they were curious why retail investors often achieve worse returns than the market. Earlier this year, for example,  it was reported that the average retail investor was underperforming the S&P 500 by 11%. Dalbar discovered that many retail investors are getting worse returns because they are buying high, and selling low - which is the exact opposite of a logical investing strategy, unless your goal is to lose money. So why are investors making such illogical, obvious mistakes?It comes back to that pesky subconscious. Dalbar discovered that many investors are falling prey to emotional and cognitive biases, which are causing them to make these illogical decisions in the moment rather than perceive the bigger picture. Below we’ve compiled a list of some of these biases, and as you read through them, consider whether you recognize any of them in yourself or your peers. 

Emotional Biases

Types of emotional bias include:

• Loss-aversion Bias. This bias means that an investor is so fearful of a loss that they sell at the first sign of trouble, rather than making an assessment based on more factors than simply how the markets are behaving that day. In a long-term view, there are times where a stock will rebound from a decline in price, so it’s important to consider the context of market behaviors.
• Overconfidence Bias: This bias is common when a retail investor works in the same sector as the companies they invest in, or otherwise has a lot of confidence in their competency of the industry. Bottom line is, investors should always check themselves before they wreck themselves, and if an investor considers their successes a result of skill and their failures a result of bad luck, it’s likely they have a bit of this overconfidence bias affecting their investments.
• Endowment Bias: Investors who experience endowment bias believe that what they own is more valuable than what they do not, and as a result they can hold on to a stock for dear life rather than move on from it and allocate those resources to better and brighter opportunities.
• Disposition Effect - This emotional bias leads investors to celebrate their wins too early and resent their losses too strongly. If a stock is doing really well, an investor under this bias will sell too early to secure their gains, when they should have waited longer to optimize the return. Alternatively, they may feel angry about how poorly a stock is doing, and insist that if they wait long enough, the stock will recover, when that's not the case and it’s best to call a spade a spade and cut their losses.

Cognitive Biases

“Sure, some of my friends do that stuff, but I’m not an emotional person,” you might be thinking. Well, that same thinking can get in the way of your better judgment too, in an ironic turn of events. Here are some common cognitive biases that can negatively affect investors’ returns. 

• Confirmation Bias: We’ve all got that one friend who wants to prove a point, and so they Google the exact answer that they are looking for, rather than looking for general information about a subject and deriving their own conclusion from that. Investors who suffer from confirmation bias will only seek out information that confirms their ideas about an investment opportunity, rather than exploring all viewpoints and making a decision from there.
• Gambler’s Fallacy, or Recency Bias: This bias leads investors to make decisions about investment opportunities based on what has happened in the recent past. If a stock is increasing in value for the past three days, that doesn’t mean that it will continue to do so tomorrow. Instead it’s better to look at the history of the market, and consider what is likely to happen from multiple perspectives.
• Status Quo Bias: Holding on for dear life is not the way to optimize returns, but if an investor struggles with Status Quo Bias, it means that they are resistant to change and will keep the same stocks for a very long time rather than diversifying their portfolio and trying new strategies.
• Home Market Bias: Similar to the status quo bias, the Home Market Bias describes investors who only look at the stock market exchange of their home country, ignoring the international economies and investment opportunities that exist globally.
• Risk-averse Bias: Investors who experience the risk-averse bias place more weight on bad news than good news, which keeps them from engaging with potentially profitable opportunities as they ultimately end up playing it too safe.
• Bandwagon Effect: This bias means that an investor simply goes along with what everyone else is doing, rather than conducting their own research and coming to their own conclusions about whether an investment is appropriate for them. 

To quote another beacon of psychological wisdom, the illustrious Dr. Phil says that when he is bothered by someone else, he’ll tell himself, “There’s something about that person I don’t like about me.” His comment suggests that if something is irritating us in our environment, it’s probably because we are reminded of something in ourselves that we would like to change. That being said, if any of these bias descriptions feel annoyingly familiar to you, push your buttons, or trigger a defensive scoff and eye roll, it’s possible that your portfolio is being negatively affected by them. We’ve already quoted enough psychologists for the day, so we’ll trust it’s common knowledge that the first step in fixing a problem is acknowledging it. Make sure that you’re maintaining an awareness of these biases so that you are able to avoid them and maximize your returns. We’ve said it before and we will definitely say it again - at NEST, we don’t rely on emotions or notions. We rely on data. We receive our data from the best firms and conduct daily analysis in-house, updating our portfolios accordingly. Our process is active, multi-faceted, and data-dependent so that it can remain insulated from biases like these. Drop us a line at info@nestfinancial.net if you’d like to start your unbiased, data-driven investing journey!  Find us on:LinkedIn  Facebook  Yelp  TwitterDISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.