Article:

Rational decision or knee-jerk reaction? The impact of cognitive bias on your investment decisions

10 September 2018

Denise Harrison, Wealth Adviser |

Generally, we all like to think we make sound logical and rational decisions. Even politicians think this, but after recent events that is more questionable than ever.

So what about the rest of us? There is and has always been too much information to be processed, sorted and stored, let alone recalled at the precise moment required. To help us survive, the brain has come up with ways to cope by simplifying and categorising information and using pattern recognition. This helps us to navigate our day-to-day lives but more often than we realise, these short-cuts and patterns trip us up. These simplifications and pattern recognitions are known as cognitive biases.

Cognitive bias means that recent information tends to be viewed as having more weight, as does information that is more readily available, and where there is a cluster of similar information.

There are 188 cognitive biases, however 18 of these have a disproportionate impact on our decision making. That’s still quite a lot to be aware of. Cognitive bias affects the way we process information in all areas of our lives, including when investing. Being aware of the potential bias in our decision-making can help us make better investment decisions - particularly during times of market stress.

We know that markets rise and fall, but overtime the general direction is up. However - when they fall significantly this is the most recent information available to us, which is also readily available in the media and constantly reinforced in a cluster via multiple media forms. The reality that, over time, markets go up does not carry much weight when we are in the eye of the storm - unless we can consider and identify that a cognitive bias might be tripping us up.

Our experiences provide a foundation to decision making and can anchor our view of what will happen in future situations. Regardless of experience and past performance, you may be increasing your risk by not considering changes that might affect future returns.

Australians love property and many have an expectation that you “can’t lose on property”. This is an example of ‘anchoring bias’. If property does well today it has much less to do with the past than it has to do with current factors. Past experience and the views formed can lead us into confirmation bias where we focus on information that supports our view and discard information that does not. If the environment has changed, we need to uncover that information which might differ from the view we currently hold.

A bias some of you might be familiar with is ‘loss aversion’. Nobody likes to lose money but hanging on to a company (or other investment) that is doing poorly and where its prospects are uncertain keeps you from investing in better opportunities. Our loss aversion keeps us hanging on to stocks instead of selling them and investing the proceeds in a better opportunity.

Our last bias to cover is ‘bandwagon bias’, where we pile in once a market or investment has already appreciated. We don’t want to miss out on a good thing but unless we do our homework and determine there is still value to be had, we won’t know if we are overpaying and just going with the crowd. Returns are as much about what you pay for an investment in the first instance as it is the price at which you ultimately sell.

Once you start to question and spot your own bias you start to spot it around you, in news and radio, and dare I say politics, but importantly also in the investment decisions you make.

You can also read about the Five Cognitive Biases that hurt investors via the Visual Capitalist.

If this raises any questions about your investment decisions, please contact us.

Disclaimer:

The information in this document reflects our understanding of existing legislation, proposed legislation, rulings, etc., as at the date of issue. In some cases, the information has been provided to us by third parties. While it is believed the information is accurate and reliable, this is not guaranteed in any way. The information is not, nor is it intended to be, comprehensive or a substitute for professional advice on specific circumstances.

The financial product advice or information in this document is of general nature only and has not taken into account the investment objectives, financial situation or particular needs of any particular person. Before making an investment decision on the basis of the advice above, a prospective investor needs to consider, with or without the assistance of a professional adviser, whether the advice is appropriate in the light of their particular investment needs, objectives and financial circumstances.