New and experienced investors alike often fall victim to our inherent cognitive biases—the natural patterns in our minds that lead us to inaccurate or skewed perceptions of reality. A decision may look like a perfect opportunity based on our current assumptions, but be a logically unsound move, or we may be basing our assumptions on a faulty set of data.
Before making any big investment decision, it’s a good idea to take a step back and challenge those assumptions and biases. Otherwise, you’ll make more emotional, illogical, and “bad” decisions.
Key Initial Steps
There are a few things you can do outright to reduce your chances of succumbing to your biases:
- Understand your vulnerability. The most important step you can take is acknowledging that your decision-making isn’t perfect. Recognizing that your mind is imperfect, and that your reasoning isn’t always as sound as it seems, can help you challenge your core assumptions and make you more flexible in your final decisions. If you believe you’re a savvy investor and a clear thinker, you’ll be less likely to acknowledge your own weaknesses.
- Get more sleep. Next, try to get more sleep. Practicing better sleep hygiene and using key nutritional supplements can help you get a better night’s sleep on a consistent basis, which can lead to clearer thought patterns. Plus, putting more sleep between your current mindset and your future decisions can give you more time to process your ruminations.
- Allow more time. While you’re at it, try to give yourself more time when making a big decision. The more impulsively you act, the more vulnerable you’ll be to interference from your emotion and whims.
- Get other perspectives. Other people can oftentimes illuminate the bad assumptions we naturally overlook in our own minds. Talking to a few other savvy investors about your decision may illuminate a key weakness you overlooked, or help you see how a part of your thought process isn’t strictly rational.
- Look for contradictory evidence. Finally, go out of your way to seek contradictory evidence. Confirmation bias makes us disproportionately seek and favor evidence that aligns with our preconceived notions—and it’s relatively easy to find that evidence if you’re actively seeking it. Instead, try to find data that contradict your assumptions.
Biases to Watch For
These are some of the most common cognitive biases investors should watch out for:
- The sunk cost fallacy. The sunk cost fallacy is our tendency to continue making bad decisions if we’ve already spent lots of time or money on them. For example, if you invest $100,000 in a rental property and you discover it needs a ton of repairs, you might be inclined to make those repairs rather than selling at a loss—even if it ultimately results in you spending more money.
- The overconfidence bias. Overconfidence bias refers to our tendency to overestimate how much we know compared to others. For example, if you have a favorite company in your stock portfolio and you read dozens of articles from experts claiming the stock is overvalued, you might value your own expertise over theirs—simply because it’s yours. You might rationalize it as being due to your familiarity with the company, or your experience investing in the past, but it boils down to disproportionate confidence in your own ideas.
- Loss aversion. It’s well-documented that human beings hate loss more than they enjoy a comparable gain; in other words, losing $10,000 on an investment is a more intense negative experience than the intensity of a positive experience from gaining $10,000. Loss aversion often makes people sell stocks prematurely, or fail to recognize how significant their gains truly are.
- Anchoring bias. Anchoring bias is all about how we perceive values. When exposed to any number, even out of context, we tend to judge the next number we see based on that initial context. For example, if you see a $30 bottle of wine, then a $100 bottle of wine, the $100 bottle will look expensive. But if you see a $500 bottle of wine, then a $100 bottle of wine, the $100 bottle will look cheap. The same can be said of investments; if you see a lot of tech stocks trading at a high P/E ratio, a relatively low ratio will look like a good deal—even if it’s still overvalued compared to the rest of the market.
- Hindsight bias. Hindsight bias makes us attribute our past decisions to knowledge, skill, or experience, even if they boiled down to luck. For example, you might see the winners in your portfolio as a result of your good decision making—rather than lucky timing.
These are just a smattering of the cognitive biases we all have to deal with on a daily basis. You can spend time reviewing the dozens of biases that have been documented, and try to counteract each of them individually, or you can apply general strategies to counteract all of them as best you can. Either way, merely being aware that your decisions could be negatively affected by your own internal biases can make you a better decision maker.