4 Cognitive Biases That Could Mess up Your Investment Returns

Cognitive biases are essentially logical errors people make when deciding about investments. Awareness of such biases should lead to more investment success in the long run.

Aug 14, 2014 at 10:00AM

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Photo credit: Lending Memo

People face myriad obstacles when it comes to investing. First off, investors need to have cash ready that can be put to work in equities.

Secondly, investors must decide in which equities they want to invest. This can be daunting task given the large amount of stocks and countries to invest in, not to mention the characteristics of different industries and the varying sizes of companies that must be considered.

To make things more challenging, a host of cognitive errors might influence investors' decision making without them knowing that they are even susceptible to such logical mistakes.

Cognitive errors happen to the best of us, and there is no shame in admitting that avoiding them is more difficult than it seems.

Here is list of widespread cognitive biases for investors to be on the lookout for when picking stocks:

1. Confirmation bias
The confirmation bias is pretty straightforward: Investors seek out data that confirms their existing beliefs and neglect to consider contradictory evidence.

This bias could lead investors to cling to a stock even though new information -- such as a bad quarterly earnings release -- suggests they should reconsider their investment thesis.

The remedy? Investors should always consider all information presented and not just the information that conforms with their previously held beliefs.

2. Illusion of control bias
This bias states that investors overestimate their chances of success and believe they are more in control of investment outcomes than is warranted.

Many speculators who engage in excessive trading fall prey to the illusion of control bias. Excessive trading accomplishes mostly one thing: massive transaction costs that take a good chunk of your profits (if your trades are profitable at all).

3. Framing bias
Investors often exhibit a tendency for relying too heavily on information they receive first. For instance, in an earnings presentation or conference call, management teams typically present their accomplishments first, which then affects the way investors judge the overall company performance.

Investors must be aware that even mediocre company results are often sold as successes and respectable accomplishments.

4. Availability bias
This bias stipulates that investors are influenced by events that are most easily recalled (are "available").

The stock market crashes of 2000 and 2008 are certainly still in investors' minds and can be classified as "easily recalled events." The result of such crashes (and experienced financial losses) drove many investors out of the stock market even though equity investing remains a valid strategy to achieve financial independence in the long run.

In addition, a stock market crash erodes investor confidence in the asset class, which makes them avoid the stock market altogether. This can be a crucial mistake as investors might miss out on strong recovery potential.

For instance, major stock indices marked their most recent lows in 2009, but both the Dow Jones Industrial as well as the S&P 500 index staged impressive comebacks subsequently.

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The Foolish takeaway
Being aware of such cognitive errors allows people to investigate and challenge their own assumptions when making investment decisions.

Knowing of the existence of such cognitive errors puts investors miles ahead of the pack and gives them the proper understanding to navigate the intricate workings of the capital markets.

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