Two “Cognitive Biases” Investors Should Avoid

Two “Cognitive Biases” Investors Should Avoid

Investor psychology, or the way you think about investing, is one of the most important disciplines any successful investor must master. Sure, the investments you choose are going to do the “heavy lifting” that create your financial success, however the biggest impact on your outcomes is what you do and what you think about your investments.

Here’s something that might surprise you:

Independent researchers have demonstrated that, on average, investor returns are only about HALF of the returns of the investments they choose.

For example, let’s say a share market has an average return of 10% over ten years. Over that same ten-year period, the average share market investor will only receive a 5% return.

Why does this dramatic decrease occur?

It occurs because average share market investors make mistakes, panic, and/or buy or sell at the wrong times. They ignore logic and make irrational or emotional decisions that decreases the effectiveness of their portfolio. This effect is driven by investor psychology, and more specifically, cognitive biases.

What Is “Cognitive Bias”?

According to the Cambridge dictionary, cognitive bias is defined as:

“The way a particular person understands events, facts, and other people, which is based on their own particular set of beliefs and experiences and may not be reasonable or accurate”.

(Source: https://dictionary.cambridge.org/dictionary/english/cognitive-bias)

In this article, I want to explore two cognitive biases that you must overcome if you want to become a more successful investor.

Taming these biases will help you build (and keep) and stronger portfolio which ultimately drives a far superior financial return.

Cognitive Bias 1: Recency Bias

“Recency bias” occurs when investors act upon immediate news or information without considering the objective probabilities of those events over a broader period of time. In other words, this bias occurs when investors use immediate news to reactively guide their investment actions, instead of using alternative (and more useful/accurate) pre-existing information (like their financial plan). Ultimately, this often results in damaging long-term consequences for their portfolio.

For example, an investor may think that a sharp stock market decline will last for an extensive period of time, causing them to ‘panic sell’ shares (in an attempt to avoid further losses). In reality, the investor’s financial plan was probably engineered to be resilient against such a decline, but instead their knee-jerk reaction ignored this fact and they acted upon ‘recent’ information only.

Cognitive Bias 2: Confirmation Bias

“Confirmation bias” is one of the most dangerous of the biases, and occurs when an individual’s beliefs (a) attracts them to information that exclusively supports their beliefs, and (b) repels information that does not support their beliefs.

Confirmation bias amplifies an individual’s beliefs that may not, in fact, be correct.

For example, an investor may believe that a certain investment vehicle, such as cryptocurrency, is the best (and only) investment vehicle for them. If they are experiencing confirmation bias, they will actively seek information that supports this belief, and ignore any information that contradicts it.

You can see the damage this bias can create—an incorrect belief, amplified by confirmation bias, can have a damaging effect on the performance of an investment portfolio.

Additionally, the Internet and social media accelerates confirmation bias, because the algorithms of many search engines and social media platforms provide users with information that they want to see.

Can We Help You Avoid Biases When You Invest?

Over the past 20 years, the team at McGregor Wealth Management has helped hundreds of hard-working families avoid the traps of these cognitive biases and accelerate their wealth.

Unlike most financial advisors who focus on market-based investment strategies (often driven by alliances with big financial institutions), the we take a more holistic and client focused approach to help you accelerate your wealth, so you can maintain (and ideally improve) your income and lifestyle in retirement.

Our process is simple and begins with a Free Wealth Potential Strategy Session, during which…

Although many participants realise there is a ‘gap’ between where they are currently, and where they’d like to be, they are relieved to discover there is a realistic way to close the ‘gap’ and achieve a more exciting ‘wealth potential’.

By simply going through this exercise, many people feel more in control of, and optimistic about, their financial future.

To explore how we can help you understand your wealth potential, get in touch to arrange a Free Wealth Potential Strategy Session.

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