How to avoid seven big cognitive biases

Human beings seem to come ready-equipped with cognitive biases related to their perceptual equipment and adaptations to the world throughout evolution. Investors who want to do better in the markets and feel better about what they are doing must learn to recognize these states of mind. Here is a summary of the major biases covered in previous articles in this newsletter (starting with the July 2005 edition), with an investment lesson to be learned from each:

Error 1: Confirmation bias causes us to rely on first impressions and to ignore further, disconfirming evidence. The lesson is to pay attention to new information and don’t stick with a losing investment just because it rewarded you at one time.

Error 2: “Anchoring” causes us to fixate on a starting number or fact. Forget that you bought a stock for $45 a share. That price has no long-term significance and there is no reason it cannot go to another much higher or lower level and stay there.

Error 3: “Representativeness” causes us to make judgments based on strong images maintained in our minds and to extrapolate based on current conditions. Investors should realize that today’s trends will not be tomorrow’s and that winners may not repeat.

Error 4: Overconfidence tends to make us place too much value on our own abilities. However, we cannot all be above-average drivers. Investors should question their own beliefs about whether they can profitably pick stocks or time markets.

Error 5: “Salience” and “availability” also cause us to overestimate or underestimate the odds of market trends. However, markets will not go up or down forever, and investors should turn to market history for a corrective to their current optimistic—or pessimistic—feelings.

Error 6: Loss aversion makes it hard to admit errors and realize an investment loss. However, it often is better to get out of a losing investment or strategy and go into a more rational, diversified portfolio.

Error 7: The “money illusion” causes us to rely on nominal values and ignore the effects of inflation. All investment returns—whether it is bond interest or capital gains on stocks—should be evaluated within the framework of long-term inflation.