As long-term investors, we must continuously analyze data and information and act upon the conclusions we draw. However, our brains—no matter how brilliant we think we are—have a limited capacity to absorb and process information. Furthermore, we are faced with a need for efficiency—we don’t have forever to reach a decision. This opens the door for cognitive biases to negatively influence our view. In this article we’ll identify the top 11 toxic investing biases we must guard against!
Cognitive biases are systematic errors in our thinking—errors that skew our judgement when processing and interpreting information and, therefore, can negatively shape our investing decisions. In order to avoid mental overload and gridlock (e.g., paralysis by analysis), our brains employ shortcuts—known as heuristics.
While these shortcuts, by and large, serve a beneficial purpose (viz., efficiency), they can, none the less, lead to decreased effectiveness—bad judgements and poor decisions. Obviously, this is something we want to avoid when making investment decisions and managing our investment portfolios!
Don’t be fooled… every investor is influenced by biases. The key to success is quickly recognizing and mitigating them!
Anchoring occurs when we rely on past information—typically the first information we receive—no matter (a) how reliable it is and/or (b) how material it is.
When it comes to investing, most of the hard data and information we get these days is fairly reliable (unless you are investing based on third-party rumors, tips and picks). The greater danger lies in anchoring to information that is no longer relevant or material to a given investment decision.
The classic example is buying a car. You start your research by finding that the average price for the car you want is $25k. Based on this information, you may reason that one being offered for $20K is a great deal! However, this initial information is only material from a broad perspective. What’s more important is the condition of that specific car—it may not be such a great deal!
From an investing perspective, consider you bought XYZ stock at $45. Over the next six months, it consistently drops—reaching $30. You tell yourself it was trading at $45 before, so it should eventually revert back to $45 at some point. However, it may never get back to $45! The fact that it once traded at $45 may be completely irrelevant if new information has come out that legitimately reprices the stock to around $30.
Rather than anchoring to past data or information, we must always be willing to reassess our judgments and decisions based on current information—information that is now more relevant and material.
This bias can be further compounded by loss aversion bias (the endowment effect). This occurs when we seek to avoid a loss—holding on to a position in hopes that we will eventually break even. For example, telling ourselves that we’re going to hold it until we get back to break-even and then get out. This tends to produce even larger losses!
To learn more about the anchoring bias, check out our article 4 Perilous Pitfalls to Avoid with Dividend-Growth Investing.
An availability heuristic bias occurs when we overestimate the importance of the information we have. As a result, we tend to overestimate the likelihood (probability) of a certain outcome occurring.
For example, the price-to-earning ration (PE) for a given stock may be trading below it’s recent or historical range. This may lead us to conclude that it is likely to increase in price. However, do we have all the information? How important is that piece of information? Is there something we don’t know… something that may be equally or more important—something that would change the probability of potential outcomes?
Another example is having information that a company’s revenue will increase over the next twelve months. We could overestimate the significance of this fact and infer that it’s earnings will also increase. However, what if the company will also experience significant cost increases (e.g., materials, labor, etc.) that will offset the gain in revenue (i.e., net income margins will remain flat)? Or worse, what if they also have increasing interest payments and net income will actually fall?
This highlights the risk in placing too much weight on the information we have!
This bias can play a role in getting caught in value traps. We may calculate that a stock is grossly undervalued. However, we may not have all the relative information. By overestimating the importance of information we have (e.g., the value component), our judgement regarding the future performance of an investment can be misguided. Stocks can always go way lower (or higher) than we think—usually based on a factor we didn’t consider or weigh heavily enough.
The bandwagon effect occurs when we allow the actions of others to influence (or substitute for) our own decision-making process. Rather than evaluating an investment for ourselves, we simply follow other market participants (the herd) without questioning it.
It’s the classic “everybody’s doing it so it must be right” approach. Furthermore, because we haven’t actually evaluated the situation for ourselves, we are more likely to be impacted by an irrational fear of missing out (FOMO). More often than not, the only thing we would actually be missing out on would be a bad outcome!
This investing bias often leads to emotional investing (aka buy high/sell low)—the complete opposite of what we should be doing in order to achieve long-run success.
To learn more about the dangers of herding, I recommend reading my article 4 Perilous Pitfalls to Avoid with Dividend-Growth Investing.
As investors, we tend to defend our decisions because they were our choices, which is referred to as the choice-supportive bias. As such, we are apt to subconsciously reinforce the belief that it was the right decision—even if new information indicates it wasn’t.
The reality is that the markets are a probabilistic system and we will be wrong frequently in investing. We must be able to continuously re-evaluate our decisions and make changes where logically necessary—not go down with the ship just because it’s our ship!
The fact that we made a choice in the past is irrelevant to the outcome of that choice in the future. The initial choice could have been a positive one… or it could have been a poor one. We must be willing to challenge ourselves, our investing process, and our investing theses.
Confirmation bias surfaces in the fact that we naturally tend to listen to and place value in information that confirms what we believe to be true. As such, we seek out information that is reinforcing and analyze it through a prism—one that shapes the data to best conform to our preconceptions or previously drawn conclusions.
For example, we tend to search for or click on news, articles and research that will likely confirm our conclusions or thesis. In other words, if we think REITs are poised to outperform, we have a tendency to only seek-out and read articles that support this belief.
The ostrich bias occurs when we decide to ignore or discount negative information—information that conflicts with our deeply-held beliefs.
This is the opposite of confirmation bias (i.e., seeking out positive reinforcement). In this case, we avoid seeking out opposing ideas to test our investing conclusions against.
This bias (as well as confirmation bias) is frequently seen in those investors who are intensely bullish or bearish on the market. They tend to seek out information, ideas and opinions that back their position and ignore or discount the other side of the coin.
In order to achieve success as long-term investors, we should always be willing to play devil’s advocate and actively test our conclusions and theses. If they are truly valid, they’ll stand-up to the scrutiny. If they succumb to the challenges, then we will have prevented this bias from impacting our decision-making process.
Remember, the goal in investing is to make money—not be right. If I’m wrong, I want to know it so I can change my course of action and make money rather than lose it!
An outcome bias occurs when we evaluate the efficacy of our investing actions based primarily on how they turn out. As such, we ignore the circumstances at the time of the decision.
Stated differently, we render a decision as right or wrong based on the outcome alone.
This bias is closely related to the self-serving bias. We are influenced by a self-serving bias when we attribute positive outcomes to ourselves and negative outcomes to external forces. For example, if an investment is successful, it was due to our skill and superior process. However, if it was a failure, it was just bad luck or the fault of other market participants (e.g., the dastardly shorts).
A combination of these two biases renders it difficult—if not impossible—to determine the true source of an investing outcome. To achieve long-term success, we must be able to ascertain if an outcome was the result of our investing process or some other variable.
Poor logical thinking (i.e., a flawed investing process) will ultimately lead you to bad outcomes in the long run. For our investing process to be successful over the long run, it must be repeatable. Outcome bias thwarts our ability to determine this. We need to be able to identify the factors and variables that impacted an outcome in order to determine if a similar action will resort in similar outcome over a larger number of occurrences!
The outcome bias can also lead investors to become overconfident and—based on past results—begin making decisions based on their gut or opinion rather than the facts, data, and process (aka Gambler’s bias).
The overconfidence bias is closely related to the optimism bias and the Dunning-Kruger Effect.
The optimism bias leads us to believe that we are less likely to suffer bad outcomes and more likely to achieve success than others. We are susceptible to viewing potential investments through rose-colored glasses. When it comes to investing, we should strive to be pragmatic realists—not optimists or pessimists.
The Dunning-Kruger effect occurs when we begin to view ourselves as smarter and more capable investors than others. We become less willing to identify and accept our own flaws and weaknesses.
The biggest takeaway from this bias is that ego is always the enemy of the investor! A healthy level of confidence in ourselves in our process is needed… but arrogance and blind faith in our abilities is deadly when investing in the markets.
Survivorship bias occurs when we judge something based on surviving information.
For example, suppose you read articles on how REITs have been great investments for highly-successful investors.
Does this mean you will become a highly-successful investor if you buy a REIT?
Of course not. You are only reading about the success stories (the survivors)—not the hundreds of accounts of investors that lost money investing in a REIT/REITs.
This is similar to studies that reveal things like the ten habits of millionaires. If you develop those ten habits in your own life, are you guaranteed to become a millionaire too? Of course not. It doesn’t mean those habits aren’t beneficial; however, we must always be careful when attempting to tie surviving information to future outcomes.
Attention bias relates to our tendency to pay attention to certain things, while ignoring others.
For example, we may focus a lot of attention on valuation—but ignore fundamentals. Or, we may place a great deal of our attention on profitability, while ignoring leverage.
Long-term success in investing requires a balanced process. We must always guard against placing too much attention on certain aspects or characteristics of a company, while placing too little on others. Failing to do so can cause us to miss a critical but hidden flaw in our investing thesis!
This is akin to suffering from the shiny object syndrome. It is easy to become pre-occupied with a great piece of the puzzle (e.g., an amazing ROE), while forgetting to examine other critical pieces (e.g., debt-to-equity). That shiny ROE may be the result of an unhealthy level of debt leverage—one that can result in a poor long-term outcome for investors. Always stay balanced with your focus and attention.
To learn more about developing a balanced and successful process, I encourage you to read our article Dividend-Growth Investing Success Is All About the Process.
Finally, the blind spot bias holds that we are naturally inclined to think we are far less biased than we actually are. As investors, we always need to view ourselves and our thinking through a critical eye. Honest self-examination is the only way to identify and avoid biases that can cost us money in investing and reduce our ultimate level of success.
Everyone experiences biases when it comes to investing. Those that achieve long-term success are those that are able to quickly identify and mitigate them when they surface!
Cognitive biases are systemic errors related to how we process information, analyze data, formulate conclusions, and make decisions as investors. As such, they represent a source of risk and danger when it comes to achieving long-term success—one we must constantly be on guard against.
In this article, we introduced 11 specific toxic biases related to investing:
While there are many other biases, these 11 represent some of the most common and most potentially damaging ones.
If you found this article interesting, I would recommend taking a little time to read some of our other similar and complimentary articles: 9 Sure-Fire Signs You’re NOT a Long-Term Investor, 8 Tips Dividend-Growth Investors Can Learn from Peter Lynch, 3 Essential Investing Principles for Dividend-Growth Success, and Paradigm Shift: The Dividend vs. Growth Investing Mindset.
If you’re interested in dividend growth investing—you’re in the right place! We focus exclusively on helping others be as successful as possible with this approach and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!
Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that portfolio with a solid process and winning mindset!
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That’s just one more reason to start your dividend growth investing today! It’s never too soon to start working towards your financial freedom!
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