One of the most difficult parts of investing is removing emotions from the equation and relying strictly on rational decision-making. Unfortunately, even our own human brains may sometimes point us in the wrong direction.
When it comes to critical thinking, reasoning, comprehension and strategy, the human brain can handle a massive amount of capacity. However, from a biological standpoint, our brain is limited to some extent by its physical size. To make up for the fact that there is a physical limitation on how much information we can store and process at a single time, humans have developed a number of cognitive shortcuts that help us along the way.
These shortcuts may have helped our ancestors conquer the world, and they may still help us safely navigate city streets to this day. On the other hand, some of these cognitive shortcuts can lead to costly investing mistakes.
Representativeness bias. Representativeness bias is a mental shortcut that we use to deal with large amounts of unique information. Instead of analyzing everything individually, we have a tendency to group similar items together in categories and make generalizations about each. For example, a person with a peanut, walnut, pecan and cashew allergy will likely know better than to sample a new type of nut. Even though that person may have never tried the new nut before, he or she can draw conclusions based on experiences with similar nuts.
While they may often work in day-to-day life, generalizations born from representativeness bias are often useless when it comes to investing. On Wall Street, the devil is almost always in the details.
“As to stocks, there are clear differences between companies, even when they are direct competitors,” says Owen Murray, director of investments for Horizon Advisors. “The strategy and culture of a company are a direct result of each company’s leadership. So even companies that look identical, such as Southwest Airlines (ticker: LUV) and United Airlines (UAL), can have very different financial results.”
“What’s important is to distinguish between a great stock – which is a great business at a fair valuation – and just a great business, which is a similarly successful company with great business fundamentals that is trading at a valuation that is too high,” Zaccarelli says.
Anchoring bias. First impressions are overly important in people’s minds because of what is known as anchoring bias. Once an investor has a certain experience with a stock, positive or negative thoughts about that stock can be hard to shake.
For example, if an investor buys a stock that subsequently gains 25 percent in the following six months, the investor may continue to see the stock as a winner even if it proceeds to drop to the original price.
Clement Thibault, senior analyst at Investing.com, says investors often make two types of costly mistakes because they remain loyal to stocks that made a good first impression.
“The first mistake is riding your winners for too long or not selling in time,” Thibault says. “The second mistake is falling in love with a losing position. The latter is more problematic since the loss is taken from the position’s initial capital and not from its winnings.”
Thibault says investors can help combat anchoring bias by consulting a professional to get an impartial third-party opinion on an investment.
Confirmation bias. Confirmation bias is essentially mental stubbornness. Once we form a belief about something, we have a natural tendency to seek out information that supports that belief and ignore information that conflicts with it.
Confirmation bias is the reason parents always seem to think their son or daughter is the best player on every sports team or the smartest kid in each class. In the parents’ minds, they see their child as the best. Therefore, they pay attention to all their child’s accomplishments and ignore shortcomings and failures.
Unfortunately, investors can have the same attitude about stocks.
“It is human nature to seek out information in any situation to support your personal theories, be that in science, shopping or even investing,” says JJ Kinahan, managing director of client advocacy and market structure for TD Ameritrade. “Successful investors tend to look for evidence that both supports and refutes their original theories, make their assessments objectively and then monitor what is happening from there.”
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