Decision-Making And The 10 Most Common Psychological Biases Of Investing

Be it BBQ judging, investing, picking out an outfit, or even choosing whether or not you’re going to show up for work tomorrow – ConvergEx's Nick Colas notes that there’s a decision making process occurring.  Quite simply, decision making is the cognitive process resulting in the selection of a final choice among several alternative scenarios.  Final choices can be opinions (as in “This brisket is an 8”) or actions (such as “I will invest in tech stocks”), and decisions are both conscious and unconscious.  For investors, financial decisions and how we tend to arrive at them are of particular importance.  The following is a cautionary tale of the 'Top 10' common biases that creep into the decision making process.  Recognizing and eliminating these biases from your financial choices will make you a sharper and smarter investor... or BBQ judge... or whatever it is that you do.

Via ConvergEx's Nick Colas,
 
Decisions in the financial arena are especially complex and are complicated by a host of outside forces.  As an investor, in particular, you should be aware that you’re subject to biases which occur during the decision making process.  Recognizing and minimizing their importance in your financial choices will make you that much better off and (hopefully) quite a bit richer.

Read on below for our list of the 10 most common biases affecting the psychology of investing.

1) Anchoring & Adjustment:  This combination occurs when initial information unduly influences decisions by shaping the view of subsequent information.  Once the “anchor” or initial information is set, there exists a bias for interpreting other information around the anchor.  Car salesmen frequently use this tactic when presenting an initial sales price, making the subsequent negotiated prices seem lower than the initial price even though they are still higher than what the vehicle is actually worth.

 

2) Attribution Asymmetry:  The concept here involves people’s tendency to attribute success to internal characteristics (such as talent and innate abilities) and to attribute failures to external factors (like simple bad luck).  Research has shown the reverse to be true when evaluating the successes and failures of others.  The lesson here is most valuable when you hit a “hot streak.”  When you experience speed bumps, don’t be quick to write them off as poor luck – there could be a fundamental problem with your strategy.

 

3) Choice-Supportive Bias:  By distorting recollections of chosen courses of action versus the rejected courses of action, people tend to make the chosen outcomes seem more attractive that the foregone ones.  Just as people more frequently remember “good” memories than they do “neutral” or “bad” memories, the belief that “I chose this option therefore it must have be superior” can lead to a false recollection of the ultimate outcome.  Learn from your mistakes – don’t forget them.

 

4) Cognitive Inertia:  This is just psychological speak for the unwillingness to change thought patterns in light of new circumstances.  Quite simply, do your homework and keep up on your investments.  If a company slashes guidance, for example, perhaps you should consider altering your investment accordingly.

 

5) Incremental Decision Making & Escalating Commitment:  These biases occur when people view a decision as a small step within a larger process, rather than as a singular choice.  As a result, this viewpoint perpetuates a series of similar decisions, when perhaps many of those decisions should be evaluated with a fresh mind.

 

6) Group Think:  Grown-up lingo for peer pressure, group think occurs when one feels compelled to adhere to opinions held by a larger group.  This one’s easy – don’t let others sway your opinion.  Groups tend to form a singular opinion based on the opinion of the loudest or most influential person in the group.  Doesn’t mean he’s right.

 

7) Prospect Theory: This theory explains that people are more likely to take on risk when evaluating potential losses; though in looking at potential gains, humans have the tendency to be risk-averse.  In other words, losses feel worse than gains feel good.

 

8) Repetition Bias:  The bias results from the willingness to believe what one has been told most often and by the greatest number of different sources.  Remember all the hoopla over Facebook’s IPO?  And then its year one performance?  Yeah, everybody though it was a hot stock and only now has it drifted above its IPO price.

 

9) Sunk-Cost Fallacy: If someone makes a decision about a current situation, based all or in part on what they have previously invested (money, time or otherwise) in the situation, they are suffering from sunk-cost fallacy.  Not matter how much you’re down on an investment, if it’s likely to never be recovered, then cut your losses and let it go.

 

10) Wishful Thinking: This “problem” happens when people are too optimistic; wanting to see things in a positive light can distort perception and objective thinking.  Just because you really really really want your investment to appreciate, doesn’t mean it will.  Investing should not be treated as gambling.

Decision making may seem an elementary topic – after all most decisions are made unconsciously given that we just don’t have time to sit down and weigh the pros and cons of each choice we make – but when decisions are of the financial nature, it can’t hurt to overanalyze.  Things like “think for yourself” and “see the facts objectively” may seem obvious, but it’s quite amazing how often such basic concepts are forgotten amidst the abundance of investment decision-making literature out there.  Behavioral psychologists have long debated biases in judgment and decision making, and we’ve weeded out the 10 most common.  Simply knowing they exist and being aware they have many victims will give you an edge and a fresh perspective.  Happy investing.