Cognitive biases

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I was recently introduced to an excellent article by Morgan Housel in “The Motley Fool” on a couple of the most common cognitive biases that cause problems for investors, cognitive dissonance and confirmation bias.  The information is not new, but what makes this article so fun is Housel’s writing style and good analogies.  A couple of excerpts should suffice to illuminate the problem with cognitive biases.

Charles Tumlin
Charles Tumlin

Study successful investors, and you’ll notice a common denominator: They are masters of psychology. They can’t control the market, but they have complete control over the gray matter between their ears. And lucky them. Most of us, on the other hand, are mental catastrophes.

Take one of the most powerful theories in behavior psychology: cognitive dissonance. It’s the term psychologists use for the uncomfortable feeling you get when having two conflicting thoughts at the same time. “Smoking is bad for me. I’m going to go smoke.” That’s cognitive dissonance.

We hate cognitive dissonance, and jump through hoops to reduce it. The easiest way to reduce it is to engage in mental gymnastics that justifies behavior we know is wrong. “I had a stressful day and I deserve a cigarette.” Now you can smoke guilt-free. Problem solved.

Classic.  And this:

Cognitive dissonance is especially toxic in the emotional cesspool that is managing money. Raise your hand if this is you:

• You criticize Wall Street for being a casino while checking your portfolio twice a day.

• You sold your stocks in 2009 because the Fed was printing money. When stocks doubled in value soon after, you blamed it on the Fed printing money.

• You put $1,000 on a hyped penny stock your brother convinced you is the next Facebook. After losing everything, you tell yourself you were just investing for the entertainment.

• You buy a stock only because you think it’s cheap. When you realize you were wrong, you decide to hold it because you like the company’s customer service.

Almost all of us do something similar with our money. We have to believe our decisions make sense. So when faced with a situation that doesn’t make sense, we fool ourselves into believing something else.

And this about confirmation bias:

Worse, another bias — confirmation bias — causes us to bond with people whose self-delusions look like our own. Those who missed the rally of the last four years are more likely to listen to analysts who forecast another crash. Investors who feel burned by the Fed visit websites that share the same view. Bears listen to fellow bears; bulls listen to fellow bulls.

Before long, you’ve got a trifecta of failure: You make a bad decision, rationalize it by fighting cognitive dissonance, and reinforce it with confirmation bias. No wonder the average investor does so poorly.

It’s worth reading the whole article, but the gist of it is that we are all susceptible to these cognitive biases.  It’s possible to mitigate the problem with some kind of systematic investment process, but you still have to be careful that you’re not fooling yourself.  Investing well is not easy and mastering one’s own psyche may be the most difficult part of all.

This article was written by Dorsey Wright and Associates and provided by Charles Tumlin of Tumlin, Levin & Sumner Group – Wells Fargo Advisors, Beaufort, South Carolina, 843-524-1114.