How can cognitive biases impact us when managing our money? David Harvie from Saxo Australia takes a deep dive into the role of our cognitive biases in behavioural finance.
Buckle up! We’re plunging into the harrowing abyss of cognitive biases in behavioural finance. These mental tricksters are like sirens luring us towards the rocks, attractive, deceptive and ultimately destructive. But have no fear: we have the answer! In this case, knowledge is power and the more we know the better we can navigate these treacherous waters. So, let’s meet these beguiling beasts.
First, let’s get this straight – our brains are treacherous liars. They’re wired with a cocktail of cognitive biases that lead us astray, particularly in the complex world of finance. These mental shortcuts, born out of eons of evolutionary survival, can steer us off cliffs in today’s financial landscape. Understanding them is akin to decoding the madness that governs the market.
Bring on the biases
Take the ‘confirmation bias,’ a devilish little demon that has us cherry-picking information to support our preconceived notions. You think gold is on the rise? You’ll start seeing signs everywhere – a glint in your bartender’s eye, a golden sunset. Meanwhile, you’re ignoring the critical data that screams it’s going to crash
Then there’s the ‘overconfidence bias.’ This is the swaggering cowboy of biases, convincing us we’re sharper, smarter, luckier than the rest. It’s the voice whispering that you’re the next Warren Buffett, even as your investments burn to the ground. You can feel this bias when you hear that voice in your head telling you this is the best idea you have ever had and you should go all in because you are so smart; we have all heard this sneaky little voice.
And let’s not forget ‘loss aversion.’ It’s the primal fear of losing what we have, often causing us to make irrational decisions. It’s the gut-wrenching instinct that convinces you to hold onto a plummeting stock, praying for a miracle, instead of cutting your losses. It is the same instinct that that keeps blackjack players at the table long after they should have folded and gone home for the night.
Then we have ‘hindsight bias:’ the ‘I-knew-it-all-along’ phenomenon. This nasty critter has us believing we predicted past events with impossible precision. Made a lucky bet on a skyrocketing stock? Hindsight bias will have you convinced you’re a clairvoyant, completely ignoring the fact that you were throwing darts blindfolded. As the old saying goes, ‘even a broken clock is right twice a day.’
Why does this matter? Because it fuels overconfidence. It tricks us into believing we can predict the future based on the past. But remember, the market is a wild beast and predicting its movements is like predicting where a balloon will land in a hurricane. Don’t let hindsight bias fool you into thinking you’ve tamed the storm.
Next, we have the ‘anchoring bias.’ This is the mental hitching post where we tether our decisions, usually to the first piece of information we come across. Say you hear a hot tip that a certain stock is worth $100 a share. That figure becomes your anchor. Even if subsequent information suggests it’s overvalued, you’ll be reluctant to adjust your expectations.
This can lead you to make misguided decisions, clinging stubbornly to your anchor while the ship is sinking. In the frenzied seas of finance, adaptability is survival. Don’t let anchoring bias chain you to a sinking ship. Anchoring bias is another reason investors throw good money after bad trying desperately to prove their original idea was true and correct.
Knowledge is power
Don’t think you’re immune, because you’re not – unless you’re not human. We’re all dancing to the tune of our cognitive biases, whether we admit it or not. They’re lurking in the shadows, pulling the strings deep in our minds, turning the rational world of finance into a chaotic circus.
As we said at the outset knowledge is power – and awareness is the first step towards liberation. Learn to recognise these biases. Question your motivations. Challenge your assumptions. Strip away the illusions and confront the cold, hard reality. It’s a bitter pill to swallow, but it just might save you or make you many thousands of dollars.
Remember, the market doesn’t give a damn about your biases. It’s a ruthless, uncaring beast, ready to devour the unwary. So, arm yourself with knowledge, tread with caution, and never ever let your guard down. Economist and investor Benjamin Graham said, “in the short term, the market is a voting machine, over the long term the market is a weighing machine.”
Your biases will lead you to be part of the voting process, trying to make decisions that are popular or smart based on poor information. Knowing and challenging your biases will guide you to the weighing machine, a machine that is famous for redistributing wealth out of the pockets of dumb investors to smart investors applying knowledge about the market and themselves to make longer term decisions.
Becoming a better investor
Congratulations! In learning about biases, you are now in a better place to be a better investor. You can make your own calls and hold your biases in better control. But if this is all too much for you and you don’t have the time, patience or interest to keep track of and challenge your biases then there is another way.
Why not employ an expert to do this for you? Someone who is trained professionally to track their biases as well as the market and make smarter decisions rather than emotional ones.
Managed investment portfolios, run by professionals, expertly crafted by seasoned money minds and soulless algorithms could help chart an even course through the boiling seas of market uncertainty. A steady captain at the helm, one trained to handle choppy waters, makes a journey well worth taking. Stay sharp, stay sane, stay invested.
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