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The Most Dangerous Thing II

Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” - Jason Zweig, Author & WSJ Contributor.

Back in November 2018, we wrote our initial "The Most Dangerous Thing" post to unpack and recognize our emotional behavioral biases. We are back for part II, with an emphasis on common cognitive biases. As opposed to emotional biases which are based on feelings rather than facts, cognitive biases affect the way we think. With the right coaching, we can modify or eliminate cognitive biases to make better investment decisions. Part of being a successful investor is identifying our blind spots before they sneak up and bite us.

Note: Professional investors have biases too. That's why we have rules that drive our investment process. We want to focus on our process and what we can control. We call it evidence-based investing or the relentless pursuit of what works.

Cognitive Dissonance - When presented with information that conflicts with our preexisting beliefs, people experience mental discomfort. In other words, humans tend to stick with ideas they believe to be true.

What's the remedy for Cognitive Dissonance?

This bias can affect advisors and investors. Let's say your advisor is quite certain the market is overvalued and decides to shift out of equities. During the next quarterly earnings season, companies report overwhelmingly positive earnings and raise forward guidance due to a strong economy. Rather than admit his mistake, your advisor refuses to acknowledge the new information and sticks to his plan.

This could have been avoided by having a disciplined investment process in place, using evidence as opposed to personal feelings, and learning from the mistake or refining the decision making process rather than doubling down.

Confirmation Bias - Selective perception that emphasizes ideas that confirm our beliefs while devaluing information that contradicts our beliefs. For example, if I feel strongly that the Fed will increase interest rates four times in 2019, I'm likely to seek out research that supports my conclusion and dismiss opinions to the contrary.

What's the remedy for Confirmation bias?

The stronger your conviction, the more you should seek out information to the contrary. Seek the other side of the trade or forecast. Virtually every time, smart people are on the opposite end of one's "can't miss" opportunity.

Illusion of Control - The tendency of humans to believe that they can control or influence outcomes, when they cannot.

What's the remedy for Illusion of Control?

Illusion of Control tends to show up with the urge to "do something." We feel empowered to trade more often than we should. To satisfy this urge, it's fine to set up a trading account to speculate.

Hindsight Bias - After an event has taken place, people afflicted with hindsight bias tend to perceive that the event was predictable. In general, people tend to overestimate the accuracy of their own predictions.

For example, back in 2007-2008, many investors would later proclaim "I knew the market was going to plunge!", when in fact, very few saw the Great Recession coming.

What's the remedy for Hindsight bias?

Examine the process leading up to good and bad investment decisions. Take notes for the rationale for making a certain investment decision. Learn from your mistakes.

Anchoring - Using a reference point to make a future decision. For example, let's say Suzy bought General Electric (GE) for $15 per share. GE is now trading at $10.00 per share and Suzy doesn't want to sell and "lock-in a loss" despite the company facing dire circumstances.

What's the remedy for Anchoring?

The market doesn't care what Suzy paid for a stock. Future decisions should be based on all available information, not an arbitrary purchase price.

Availability - Mental shortcut that causes people to estimate the probability of an outcome based on how familiar that outcome appears in their lives. For example, investors will often choose investments based on information easily available to them i.e. from friends or advertisements, without engaging in proper due diligence.

What's the remedy for Availability bias?

Everyone has a different situation and circumstance. What's good for Suzy Orman might not be good for you (same goes for your friend or neighbor). Ignore current investment trends and focus on what's best for your plan.

Outcome - Tendency of individuals to decide to take a course of action based on the outcome of past events, rather than observing the process by which the outcome came about. When choosing a mutual fund for potential 401k investment, many investors comb for the best performing fund. While the mutual fund had a great run, the investor may fail to understand the excessive risk the manager took to generate the returns.

What's the remedy for Outcome bias?

Understand the factors that contributed to the favorable outcome. Widen your lens to include a longer time horizon. Ask yourself, is the outcome the result of skill or (unsustainable) luck?

Recency - People tend to emphasize recent events and observations than those that occurred in the near or distant past. Pure Portfolios sends out a quarterly check-in asking clients how they feel about the financial markets. The 4th quarter responses were overwhelmingly negative due to the year-end sell off. This is recency bias at work.

What's the remedy for Recency bias?

Take a big picture view. This is a particularly dangerous bias in investing as the best performing asset classes of today are often the worst performers tomorrow. For example, many real estate investors in 2007 thought the good times would last forever. They learned an expensive lesson! This is the cyclical nature of investing.

We all have cognitive biases. The good news is they can be managed or eliminated through education and practice. Whether you're a do-it-yourself investor, advisory client, or financial advisor, by understanding the blind spots, we can encourage the right behaviors and avoid disastrous mistakes.

Source: CFA Institute's "Understanding Behavioral Biases" by Michael Pompian, CFA.

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