How to Reduce the Impact of Cognitive Biases

The key to successful investing is about more than just managing your money; it’s about managing your mind.

Common cognitive biases, including confirmation bias, loss aversion, herd mentality, recency bias and overconfidence, are all “mental shortcuts” common to all human beings. Let’s talk about a few more biases that can affect investment decisions and explore ways to help mitigate their impact. 

Anchoring Bias

This mental shortcut leads us to rely too heavily on the first piece of information we encounter (the anchor) when we make decisions. For investors, this might mean focusing on the purchase price of an asset or leaning too heavily on an outdated valuation metric.

Perhaps you bought a stock at $100 per share. No matter how the underlying fundamentals have changed, you may be unwilling to sell for less than $100 per share, even if the fair value has declined to $80. 

Mitigating anchoring bias

• Regularly reassess the intrinsic value of your investments based on updated fundamentals such as financials, growth potential, and market developments.
• Remember that your original purchase price is a historical fact and not a predictor of future performance. Evaluate investments as if you were purchasing the stock today.
• Instead of fixating on one number, consider a range of information including price-to-earnings ratios, revenue trends, or industry benchmarks.

Availability Heuristic

This cognitive bias refers to the tendency to overestimate the likelihood of events based on how easily examples come to mind. Influenced by this bias, investors can focus too heavily on recent or newsworthy events. 

For example, after a major market downturn, fear of more losses may weigh disproportionately on investors’ minds. As a consequence, they may become more cautious and risk averse. Conversely, a booming market may encourage investors to take more risk than is prudent.

Mitigating availability heuristic

• Read beyond the headlines. Look at historical data and trends, even if they aren’t widely discussed. 
• Avoid acting on sensational news. Remember, media coverage often emphasizes the extremes rather than the steady middle ground where most investments lie.
• Combine long-term historical insights with your personal investment goals rather than allowing recent market events to influence you.

Endowment Effect

Under the influence of this bias, we tend to overvalue assets simply because we own them. This can lead to holding on to underperforming assets longer than might be wise.

Say, for example, you own shares in a company for which you once worked or stock that was a gift from a family member. You might find it difficult to sell that stock even if selling would be the best decision.

Mitigating the endowment effect

• Take emotion out of the equation by asking yourself if you would buy the stock now if you didn’t already own it.
• Get an unbiased perspective by speaking with an advisor or analyst who is not emotionally invested.
• Evaluate how the asset fits into your broader portfolio. If it doesn’t align with your goals, it might be time to sell.

Status Quo Bias

Change can be uncomfortable. Status quo bias reflects our preference for things to remain the same. Investors who feel anxious about change might be tempted to stick with outdated portfolios, and neglect to rebalance or diversify as markets evolve and their financial circumstances change. 

Mitigating status quo bias

• Make it a habit to review your portfolio at least once a year.
• Consider automated rebalancing to make sure that your portfolio remains aligned with your goals and risk tolerance.
• Stay informed about market trends, risk, and opportunities so you can alter your strategy when necessary.

Mental Accounting

This bias refers to the tendency to assign different values to money depending on its source, purpose, or location. For instance, an unanticipated bonus might be characterized as discretionary spending money while income from investments is sacrosanct and never to be touched. This can lead investors to make decisions in isolation rather than taking their entire financial picture into account. 

Mitigating mental accounting

• Always look at your investments as part of an overall portfolio rather than evaluating them in isolation.
• Remember that money is fungible. No matter its source, all funds should work to serve your long-term financial goals. 
• Take advantage of the many tools and apps available to monitor your entire financial picture instead of focusing on individual accounts or assets.

How to Help Prevent Biases From Affecting Your Decisions

Understanding cognitive bias isn’t just an academic exercise. It’s a vital step in improving your investment decision-making capacity. Here are some ways to put this information into action.

Self-awareness is a boon in every aspect of life

Understanding your motivations, your triggers, and your emotions can benefit you in every aspect of life, but it comes to investing, your emotions and the way you think can cost you money. 

Take the time to examine your thought processes. Question yourself. Remember the biases we can all fall prey to and ask yourself if these mental shortcuts are figuring into your investment decision making process.

Build a System

Look for ways to isolate your investments from your emotions. With the variety of apps, tools, and automated options available, you can automate much of the investment process. Monthly contributions, rebalancing, diversification—all of these things can be done automatically to reduce the amount of emotional interference.

Work with a trusted financial advisor

When you choose to work with a financial advisor, you can benefit from objective advice that can serve as a counterweight to your own biases. In volatile markets or personally challenging periods, your advisor can help you maintain discipline and stick to the plan you’ve developed to pursue your long-term financial goals.

Education is key

The more you understand about the psychology of investing, the better equipped you’ll be to identify and guard against the mental shortcuts that can be detrimental. 

A good place to start is Thinking Fast and Slow, by Daniel Kahneman. One of the pioneers in behavioral finance, he won a Nobel Prize in economics for his work. There are many other highly readable books on the topic that will get you thinking more about how we all make investment (and other) decisions. 

Be patient

Many biases, for example loss aversion and recency bias, are the product of a focus on short-term events. Investing is a long game. Keep your eye on the bigger picture.

The Takeaway

By becoming more aware of and attuned to the way cognitive biases can shape your decisions, you’ll be better prepared to manage your investments with enhanced clarity and confidence. 

If you want to navigate the financial markets while avoiding the mental traps and pitfalls that lie in wait for us all, ordinary investors and professionals alike, awareness and ongoing learning are the best tools for success.