The Willy Wonka world of Cognitive Biases in investing and what to do about it!
It should come as no surprise to read that we humans are irrational and use mental shortcuts most of the time in decision-making. Below is a simple visual example that illustrates this perfectly. You see two circles, both of which are surrounded by several other circles. The question is, which of the two inner circles is larger?
Those who’ve never seen this before will say the circle on the right is larger. If you have seen this before, you might say, “Well, I know that the circles are of equal size”. And, of course, you are right. But what’s happening here?
The first is the brain has notoriously bad at perceiving absolute values. So judging the total size of something is incredibly difficult, and the brain constantly uses other cues to extract information from the environment.
The second thing we learn is knowing this; you can always adjust for the brain’s mistakes. In this case, perceiving one circle as larger than the other.
The third observation, though, is even though you know they’re of equal size, it doesn’t actually change your perception.
This happens because your brain is constantly filling in information that isn’t there to give you a complete image of the complex world around you. And the only way for your brain to do that is to make a lot of assumptions. Most of the time, your brain is right in these assumptions, but once in a while, these assumptions are wrong. And then they lead to errors in your perception and your judgements.
Let’s examine some key ones that pop up during the three-stage investing process and how we can overcome them:
1. Defining our investment Universe. AKA what you decide to spend your payday money investing/speculating on. During this phase, we encounter Availability Bias. This bias can be considered a product of and influences our decisions based on information close to home (Home Bias) and recent information (Recency Bias).
How to Overcome: To avoid this problem is to get out of your comfort zone. Try to get data that is not necessarily easy to access, and don’t focus your attention on what’s readily available. Do some extensive research and try to gather as much information as possible.
2. Constructing the ideal strategy for investing. We search for information on our potential investment choice and seek and process much information in this stage. When we make a forecast, we really want to think that this forecast is accurate, and we typically seek a lot of information that confirms our beliefs rather than looking for information that contradicts them. When you only seek information confirming your initial forecast, what you’re doing is increasing the precision artificially of an estimation you’ve just made. You might actually be underestimating the risk associated with a decision based on this initial forecast.
This stage presents us with three Cognitive Bias challenges to recognise and overcome. These are Anchoring Bias, Confirmation Bias and Overconfidence Bias.
How to overcome: In the second stage, when processing information and forecasting future return or level of risk- It is strongly recommended to look for information that may contradict your current forecast contradicts your current belief rather than looking for information that would confirm it. Furthermore, when dealing with Overconfidence Bias, in particular, Have an open mind about the possibility of making a mistake. When you have the humility to admit your weaknesses, you will also gain the insight to overcome them. Reflect on any errors. Actively seek and pay attention to feedback. The concept of Johari’s Window is a vital tool to understand and use at this stage.
3. Adjustment and portfolio rebalancing over time. In this stage, it’s very likely that at some point in time, you will have to readjust your portfolio, and re-balance your portfolio to get back to, for example, a target proportion of your wealth invested in a particular area.
The two challenges this stage throws at you are: The Endowment Effect is said to be triggered by a) ownership of an asset and b) loss-aversion. And also the Disposition Effect.
How to overcome: For the last stage, rebalancing and readjusting, you should really stick to the plan. Think about your initial strategy, what it implies, and what type of sell and buy order you need to place. Then stick to this original strategy with all investments strictly dictated by the original strategy.
Finally, once we have understood and overcome the biases in the investment process, we need to be aware of the ones that pop up when evaluating your performance. These are Hindsight Bias (I knew it) and Bias Blindspot (don’t see your own biases).
Advice for avoiding the final two biases and also to help with every bias described in this article: Once you’ve put together your assets, keep track of everything you buy and everything you sell. Keep a detailed diary to help you log everything. When we look at the process of investing- our decision process starts with information gathering. It is then followed by information processing, and you take an actual decision. So it’s essential to know how we arrived at a conclusion, so it is advisable to keep a log of your transactions and the information that led to them. So keep track of which cryptos you chose to buy and sell and why you chose to buy and sell them. What was the information that was available to you at the time? How did you evaluate it, and why did you make this choice?
This article has demonstrated one thing: we are only human and prone to decision making based on mental shortcuts. These can sometimes bring us success, but they can also lead to impaired judgement which translates to actual loss of invested capital.
By understanding the biases that are most likely to arise during each of the three investment phases, we can be prepared to recognise them and form a strategy to help us avoid the negatives that each brings.
Happy Trading, fellow whales, dolphins and minnow cryptocurrency enthusiasts. Enjoy the ride!
