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Cognitive Biases and Your Investment Decisions

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I can guess that some readers will be thinking – “OK – when I make an investment, I have to consider the company’s balance sheet, its risk exposure, its place in the economic cycle, its yield, its outlook and a whole bunch of other things. And now I have to think about my cognitive biases???”

Yes.

And grappling with cognitive biases has become even more important than ever during the current market volatility. An investor can be forgiven for nervously looking at portfolio statements while listening to what sounds like the gloom and doom of the day’s financial news.

Providing an explanation of cognitive biases that does not read like an excerpt from a university psychology course makes for a challenge. Put simply, cognitive biases are the complete opposite of rational considerations in decision-making.

In this example, rational considerations in investment decision-making include the criteria mentioned above, although the weighting given to each one will vary between an investor and his or her financial advisor. Taken together, the rational considerations can provide an answer to the question: ‘Given the factual information that I have available, what is the best move here?’

However, cognitive biases are not based in fact but in beliefs that can sway our decision-making. In an example that occurs in investing, a familiarity bias would mean that we choose an investment because we are familiar with the company or its products even without reading the balance sheet. Someone who uses a MasterCard every day might feel more comfortable investing in that company than another one. Someone who has driven Ford automobiles for years might lean towards investing in the Ford Motor Company.

A confirmation bias would mean that we choose an investment that conforms to a belief that we hold before encountering the investment. This may have influenced many to go into pot stocks.

A bandwagon bias leads to investing in an asset or a category because we believe that everyone else is getting into it. That belief may have driven much of the growth in bitcoin.

Advisors often find themselves confronted by clients who do not separate the rational from the emotional, explains Jay Nash, Senior Vice-President, Portfolio Manager and Investment Advisor at the London branch of National Bank and a 21-year veteran of the financial sector. Money is a very emotional thing, and emotions tend to be the enemy of careful investing, he believes. For example, the trend away from defined benefit pension plans, in which the employer carries the liability, and towards defined contribution pensions, which place the responsibility on the employee’s shoulder, have made some investors more sensitive to the short-term movements of the market, Nash says.

Side-stepping cognitive biases means following a process through all markets, while acknowledging that no process works 100% of the time in all market cycles.

That can mean accepting the possibility of being wrong periodically. Most people want to be right, which can lead to changing a strategy with each new piece of information. That approach rarely works, Nash says.

“Buy low and sell high” sounds easy, until you recognize that “low” is normally when everyone is panicking and “high” is normally when everyone thinks things are great.

The first step in dealing with this trap is understanding your personal biases. The next is understanding the limits of these biases as they relate to portfolio loss. It’s easy to say you want all of the upside and none of the downside, but this just is not a realistic expectation.  How much return one can expect from investing is highly correlated to the risk being taken. Investors should start with how much downside they can handle and then look at how best to participate in the upside.

Since we are all human, it is reasonable to believe that we all have at least some cognitive biases.

The potential cost of cognitive biases in an investment decision occurs because these biases can lead to the wrong decisions at the wrong times, Nash suggests.

If we accept that panic and emotion played a large part in the sell-off during the fourth quarter of 2018, it will likely be viewed as “emotional selloff” in the history books since it involved a large amount of selling without rational economic reasoning.

The decision to buy or sell a stock or market position should be based on a long- term process and not a short-term piece of data.

Several strategies can help the investor cope with all of this.

Related: Volatility, Europe & Your Investments

One of these strategies involves cognitive tests in which an investor asks himself or herself some hard questions such as:

1.Your portfolio has a good year last year and rose from $100,000 to $120,000. The year is off to a rough start and you’re now worth $110,000. Did you make 10% over the past 13 months? Or have you lost $10,000?

When one considers the scenario proposed, do they first think that they made 10% or that they lost $10,000? For most, the immediate emotional reaction is that they have lost $10,000. Only when one steps back and examines the scenario rationally do they come to terms with the positive 10% return….and even then there is normally a “but…. I’m down $10,000”.

This question points up high-water marking, a very common cognitive bias. We all understand that there will be ups and downs in the market, but we tend to view our portfolio’s net worth from the highest point that it was recorded –- the “high- water” mark. Falling below the high-water mark feels like a loss, Nash explains.

This bias becomes expanded during times of volatility as we tend to view the market correction through the lens of “what am I losing?” versus “what can I add to the portfolio at a better price?”

In another test question:

2. You have a choice to receive $100 cash or a 1 in 50 chance to win $10,000. Which do you take?

The chance is actually worth $200 as 1/50th of $10,000 is $200. It should be taken and a logical mind would select this. While losing would leave you right where you started, many end up feeling that they just lost $100. This could be called an example of confirmation bias in which a person focuses on information in a way that confirms preconceptions.

While the Know-Your-Client process and calibrating a client’s risk tolerance is all-important, protecting him or her from cognitive biases in the next correction needs more than that. A deeper relationship between advisor and client is required, Nash says. Ideally, an advisor can stay on top of a client’s changing circumstances because cognitive biases can be fluid in nature and change when unrelated events in a client’s life change.

Disclosure: I do not hold any shares in any of the companies mentioned in this article and have no plans to purchase any of them.

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