Overcoming Common “Cognitive Biases” in Investing

Aug 29, 2022
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A cognitive bias is a “systematic error in thinking that affects one’s decisions and judgments.” Researchers in psychology have cataloged nearly 200 such biases(!), but we’ll focus on five that regularly affect investors and explain how SMI’s investing approach can help you overcome them.

  1. Loss Aversion
    Everyone is “averse” to suffering financial losses! But the loss aversion bias means more than that. It means that losing money packs such a powerful emotional punch that we have difficulty assessing losses objectively.

    Research suggests that people feel the emotional pain of losses much more acutely than the pleasure of gains. As Dan Ariely and Jeff Kreisler put it in their book Dollars and Sense, “We feel the pain of losing $10 about twice as strongly as the pleasure of winning $10.”

    The authors note that loss aversion can prompt investors to “sell winning stocks too quickly — we don’t want to lose those gains — and keep losing ones too long — because we don’t want to realize the loss.”

    SMI’s approach to investing, in which sell (and buy) decisions are guided by a non-emotional process, acts as a counterweight to the loss aversion bias. By taking cues from data-driven momentum signals, SMI investors avoid selling too quickly or hanging on too long.

  2. Anchoring
    The anchoring effect describes the tendency to “anchor” one’s thoughts to a reference point, even if the reference point has no logical relevance to the decision at hand. Anchoring often emphasizes initial information, with the first input becoming a point of comparison for all subsequent inputs.

    If you’ve ever been to an auction, you’ve seen anchoring at work. The auctioneer first describes the item and then might say, “Who will open the bidding at $500?” $500 may be a figure with no particular basis, but it becomes the anchor in bidders’ minds. They will assume the item must be worth at least $500 if that is the starting price.

    In investing terms, the purchase price of an investment becomes an anchor. Subsequent decisions related to that investment, especially concerning selling, will be influenced by that initial price. Because of anchoring, many investors will hold on to an unprofitable investment for too long. They can’t bring themselves to sell until it gets back to its “starting” price.

    SMI’s active strategies counteract the anchoring effect by employing a clear selling discipline. (The active strategies include Fund Upgrading, Dynamic Asset Allocation, and Sector Rotation.) In Upgrading, for example, when a recommended fund drops out of the top 25% of its peer group, we replace it — no matter the starting point. When the performance numbers tell us it’s time to move on, we move on.

  3. Recency Effect
    People tend to give greater weight to recent information than to information received earlier. This is why attorneys carefully hone their closing argument before jury deliberations begin. Those final remarks likely will carry more weight with jurors than hours of detailed testimony.

    In investing, recency bias leads investors to focus too much on “what’s happening now.” Bear market rallies provide a good example. The bounce off a recent low can quickly persuade investors that the worst is over and that a new bull market is underway, despite broader evidence (such as longer-term trends or underlying patterns of weakness) that may suggest otherwise.

    SMI’s process takes “what’s happening now” into account, of course, but in the context of a larger momentum-based framework that helps our members resist the siren song of the recency effect.

  4. Confirmation Bias
    This describes the tendency to seek out — and give weight to — information that confirms an already established outlook while disregarding information to the contrary.

    For example, an investor convinced that cryptocurrencies are headed for the stratosphere will look for pro-crypto articles and minimize crypto-related setbacks. In contrast, one who thinks cryptocurrencies are a disaster waiting to happen likely will seize on every bit of negative information as a confirmation of his anti-crypto viewpoint.

    At SMI, we help you avoid confirmation bias by providing balanced and wide-ranging information — on everything from alternative investments to Federal Reserve policy. And although we are committed to our trend-following strategies and believe them to be effective over the long term, we never hide that our strategies sometimes struggle because of trend reversals or because a trend has yet to take hold. We provide regular performance updates so you can gauge how our strategies, and the stock and bond markets in general, are performing over various periods.

  5. Overconfidence Bias
    If you’ve ever run into someone claiming to be a terrific market timer or who insists a particular investment is a “sure thing,” you have seen overconfidence bias in action. Overconfidence leads people to believe they know more than they do.

    Because markets are unpredictable, investors must be humble. Investing involves dealing with probabilities, not banking on certainties.

    Of course, humility isn’t just an investing virtue. It is a Christian virtue. As believers, we are to be humble before God but also humble in our general outlook on life. We recognize that we are finite creatures, prone to faulty understandings and errors in judgment.

    Still, God calls each of us to be faithful stewards, so we must have an appropriate level of confidence in the investing area. We should not be overconfident, but neither should we be paralyzed with fear.

    To that end, SMI helps you learn what you need to know about investing. We provide a non-emotional, rules-based approach — along with practical tools — to equip you to invest rationally and wisely.

Written by

Joseph Slife

Joseph Slife

Joseph Slife has been a news writer for the Associated Press, a college instructor, and a radio host. He and his wife Joye have three grown sons.

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