Are Your Own Biases Keeping You From Profiting?

There's no doubt that the big banks were neck-deep in the muck that created the Great Recession. But with mea culpas and regime changes from all the major players, why are investors still shunning them now that they're performing well?

Three prominent cognitive biases -- anchoring, the negativity bias, and the empathy gap) -- may be stopping you from investing in the money-handlers. Once we clear the air, you may have a better view of how bank stocks can improve your portfolio for the long run.

Anchors aweigh
Sometimes a past event becomes so engrained in our minds that it influences future decisions -- a phenomenon called anchoring. With the financial crisis only recently behind us, it's no surprise that many investors have a hard time letting go of the past, even when banks' operations have improved. Let's look at some of the players in the financial sphere, their past indiscretions, and their current condition.

Financial Institution	Top Indiscretion	Current Condition
AIG (NYSE: AIG  )	Insured the riskiest class of investments, a practice that led to short-term profits, but longer-term disaster.	Government ownership has been reduced to a fifth of the total company Has positive earnings in past two years, both topping $10 billion
Goldman Sachs (NYSE: GS  )	Bought subprime mortgages and bundled them into mortgage-backed securities to sell to pensions and other investors, even as it hedged itself against the housing market.	Goldman is currently the leader of global equity trades in 2012, but is hand-picking its deals so as to maintain a lower risk profile
Wells Fargo (NYSE: WFC  )	Allegedly defrauded the Federal Housing Administration by originating questionable mortgages.	1 in 3 mortgages are originated with WFC nationwide Reported sixth consecutive quarter of record earnings (Q3 2012: $4.9 billion)

None of the banks operating today have a halo around their heads. But with increased regulations, federal lawsuits, and internal reform, many are getting back to the basics of their business -- and profiting from it.

Accentuate the negative, eliminate the positive
Even with good news from the financial sector coming in left and right, it's difficult to focus attention on the positive when negative events are so sensationalized. But it's not just media attention that causes us to focus on the negative. Our brains have a general tendency to give more weight to negative information than positive – what's known as the negativity bias.

Consider, for example, the recent trading kerfuffle at a JPMorgan Chase (NYSE: JPM  ) office in London that resulted in losses of $6 billion. In that scandal's wake, few investors will remember that JPM was one of the only banks to emerge from the financial crises whole, and that it remains profitable even after the rogue-trading incident.

Mind the gap
Now, as Foolish investors, we know that we need to take our emotions out of investing or suffer the consequences of buying high and selling low. But according to the empathy gap, we tend to underestimate the power of our emotions on decision-making. Say you had a mortgage with Countrywide that resulted in foreclosure; it would be understandable that as an investor, you'd have emotional barriers against investing in Bank of America (NYSE: BAC  ) .

But if investors can divorce themselves from their feelings, they might realize that Bank of America has been slowly reclaiming its footing. Since it's currently trading at around 73% of its tangible book value, it may be a solid value play.

A Foolish takeaway
It's not uncommon to have biases influence everyday decisions. But when you're deciding on investments, be sure to take a minute and question your aversion to a certain company or sector. If your decision isn't supported by the fundamental research any investment requires, you may be victim of a cognitive bias -- and you might be holding your portfolio back from its full potential.

If you still find it hard to get over your emotional struggles with justifying an investment in financial firms, consider how Wells Fargo's dedication to solid, conservative banking helped it vastly outperform its peers during the financial meltdown. Today, Wells is the same great bank as ever, but with its stock trading at a premium to the rest of the industry, is there still room to buy, or is it time to cash in your gains? To help figure out whether Wells Fargo is a buy today, I invite you to download our premium research report from one of The Motley Fool's top banking analysts. For instant access to this in-depth take on Wells Fargo, click here now.