3 Cognitive Biases That Can Derail Long-Term Investment Success

As human beings, we naturally have emotions and biases. These biases are ingrained in our thinking and have developed over generations as survival instincts. While they have served us well in many aspects of life, investing requires a very different mindset.

Understanding some of the most common cognitive biases can help us to recognize when they are present and attempt to limit the bias from impacting our decision making.

Recency Bias

Recency bias is the tendency to overweight recent events and assume the future will look similar to the recent past.

While this ability to discern patterns can be useful in some areas, this bias is usually detrimental when it comes to investing. 

Investors may gravitate toward funds or asset classes that have performed well recently, while avoiding those that have underperformed. In reality, areas that have lagged may be more attractively valued and positioned for future returns. Constantly rotating into what has recently done well can lead to poor long-term outcomes.

Recency bias also tends to show up after both bull and bear markets. After strong stock market performance, conservative investors can become comfortable adding stock exposure. Conversely, after market downturns such as in 2001 and 2009 we saw that some investors were apprehensive about reinvesting in the stock market for fear of another drawdown. In reality, the best time to invest in the stock market is often in the midst of a bear market, and a strong bull market can be the time to start trimming positions.

Systematic investing can mitigate recency bias. For example, an investor can aim to hold 60% of their portfolio in stocks and 40% in bonds, regardless of market conditions. If the portfolio fluctuates by more than a predetermined percentage, such as 5%, the portfolio is simply rebalanced to the desired 60/40 split. Maintaining an overarching asset allocation, which aligns with your financial goals, can help to take a portion of the emotion out of investing.

Confirmation Bias

When forming an opinion, it takes conscious thought to consider the opposite stance than which you have, and why you might be wrong. 

Charlie Munger was well known for this type of thinking and regularly challenging his own assumptions. Munger would work to get away from only thinking about why an investment decision would work out in his favor. 

In business, there are examples all through history of confirmation bias. Take the film company Kodak. Despite inventing the first digital camera, Kodak refused to take the digital revolution seriously in the 90’s through early 2000’s. The leadership focused their efforts on the film industry, pointing to the popularity of their film products, failing to see that the future was digital. Kodak had the ability to shift to digital many times, but instead chose to focus on what they do “best” in producing film, and the company ended up going bankrupt in 2012. Many leadership teams fall into the trap of confirming why what they’re doing will work, rather than trying to see where they could be missing something.

Recognizing and working to overcome confirmation bias can help us make better decisions in every facet of our life.

Loss Aversion

Loss aversion refers to the tendency for losses to feel more significant than gains of the same size. 

In other words, losing $100 typically feels worse than the satisfaction of gaining $100.

A simple example, if someone were to hand us $100, but then we find out that we owe $50 in taxes, it often feels worse than if someone had simply given us $50. The net outcome is the exact same, but since there is an element of loss involved, we feel as though we have lost $50.

With our investment portfolio, we can be more likely to hang on to losers and trim winners. We hold onto a hope that the investment will recover to avoid a loss, when in reality, the position should be evaluated for its investment potential, not to merely recoup a loss. In some cases, it can be beneficial to sell a losing position to offset gains in the portfolio elsewhere, improving after-tax returns. 

As Peter Lynch famously said, “Selling your winners and holding your losers is like cutting the flowers and watering the weeds".

Final Thoughts

The key to overcoming cognitive biases is to recognize when they are present. A disciplined, systematic approach to investing can eliminate many cognitive biases, and improve investment results.

-Bill Rautiola, RICP ®, AIF ®, PPC ®

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss. Asset allocation does not ensure a profit or protect against a loss. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.