A cognitive bias is a mistake in reasoning, evaluating, remembering, or other cognitive processes, which occurs as a result of holding onto one’s preferences and beliefs regardless of contrary information. In other words, a cognitive bias is an error, which gets in the way of logical thinking. An example of cognitive bias is “confirmation bias”. I am sure most of you have heard of “confirmation bias”, which is the tendency to interpret new evidence as confirmation of one’s existing belief. Let’s say you believe that Tesla stock is going to skyrocket, so you start searching for articles that talk about why Tesla is the investment of the year. All the Tesla articles you research will help you confirm your existing belief that Tesla is indeed where you need to invest your capital. This is confirmation bias.
In 1995, Charlie Munger, a billionaire investor, gave a speech – “The Psychology of Human Misjudgement” – to an audience at Harvard University. In his speech, Munger talked about 25 cognitive biases which led to human misjudgement. I have found these biases to be highly important in investing and in life to the point where I have framed these 25 biases, and I glance them everyday. In this blog post, I will talk about 3 of the 25 cognitive biases that I have found to be most useful for an investor. I would recommend checking out all the 25 biases that Charlie Munger presented (here is the transcript, and here is the YouTube video of his speech).
- Doubt-Avoidance Tendency – The idea is that if you are unsure about a decision, you will try to remove any doubt by making ill-informed, quick decision. Doubt causes puzzlement and stress, so in order to remove that doubt, you might act recklessly. For example, assume that most of your portfolio comprises of Apple shares. You heard on the news that one of Apple’s suppliers from Japan said that they didn’t sell as many capacitors as they expected because Apple’s order was low. After this news, Apple’s stock plummeted because speculators were convinced that Apple is slowing down. What if Apple got a different supplier for part of its order? But what if Apple is actually going down? What do you do? Do you sell? Well, if you analysis/logic that got you to buy Apple shares in the first place is still intact, then you need not worry about the external noise. However, if you didn’t recognize the “Doubt-Avoidance Tendency” bias, then you might have been compelled to sell; Afterall, you do not want to deal with all the stress, confusion, and uncertainty, right? As an investor, it is crucial that you recognize this cognitive bias and schedule deliberate delays before making any rash decision. Patience is the key to dodging this cognitive bias.
- Over-Optimism Tendency – This is the idea that excess of optimism is the normal human condition. Humans are so self confident in their rationality that they think all their decisions are well considered. For example, you might be wondering if you should buy Tesla stock or not. You believe that it is the car of the future, and that 50 years from now everyone is going to drive a Tesla. You are clearly optimistic about this company. Now, if you looked at the financial statements of Tesla, you might have questioned if Tesla could sustain its business model for the next 5 years leave alone being around for the next 50 years. As an investor, it is important to have a checklist that you go through before making a decision. Have you looked at the financial statements? Do you like the management? Does the company have a moat? The key to dodging “Over-Optimistic Tendency” bias is by asking yourself – When could your expected outcome not work out? What are the various ways of failure?
- Deprival Super-Reaction Tendency – This is the idea that refers to people’s tendency to strongly prefer avoiding losses than to acquiring gains. Your displeasure in making $100 loss is far greater than your pleasure in making $100 profit. This concept also applies to how you do not want to miss out on a “great” opportunity. For example, imagine you turned on the TV and saw that Elon Musk, the CEO of Tesla, is about to make Tesla a private company. You hear him say that this is the last chance to buy Tesla shares. You realize that your window of opportunity to invest in the future of automobiles is closing. You do not want to miss (lose) this opportunity. So, you end up taking a rash decision and buy Tesla shares. Your decision was driven by the possibility that you will not have this opportunity in the future. The key to dodging this bias is by talking with people who do not believe in the idea that you are proposing (devil’s advocates); learn how to handle mistakes, analyze new facts that change the odds, and step away from your losses if the value of your investment has diminished.
Hope you learned a little and found this blog post helpful. We talked about 3 cognitive biases that you could face regularly as an investor. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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