Cognitive vs. Emotional Investing Bias: An Overview
Everybody has biases. We make judgments about people, opportunities, government policies, and of course, the markets. When we analyze our world with our own biases, we put our observations through a number of filters manufactured by our experiences, and we're not just talking about stock screeners. We're talking about the filters we put our decisions through that sometimes make them biased. Individuals may or may not necessarily rationalize that their decisions are being made based on biases they have developed.
In general, all kinds of day-to-day activities are primarily driven by behavioral patterns. These same behavioral patterns can also influence investing actions.
For most people, it is impossible to be unbiased in investment decision-making. However, investors can mitigate biases by understanding and identifying them, then creating trading and investing rules that mitigate them when necessary. Broadly, investing biases fall into two main categories: cognitive and emotional. Both biases are usually the result of a prejudice for choosing one thing over the other.
- Identifying and understanding unprofitable cognitive and emotional biases can help a trader improve their total return.
- Cognitive biases involve basing decisions on established concepts that may or may not be true.
- Emotional biases are often spontaneous. They involve basing decisions on individual feelings.
What Is Cognitive Bias?
Cognitive biases generally involve decision-making based on established concepts that may or may not be accurate. Think of a cognitive bias as a rule of thumb that may or may not be factual.
We’ve all seen movies where a thief wears a police uniform to pass through a security checkpoint. The real police officers assume that because the person is wearing a uniform like theirs, they must be a real police officer. That’s an example of a cognitive bias.
What does a fake cop have to do with your investment choices? You make the same types of assumptions that may or may not necessarily be true. Here are some examples:
- Confirmation Bias: Have you noticed that you put more weight into the opinions of those who agree with you? Investors do this too. How often have you analyzed a stock and later researched reports that supported your thesis instead of seeking out information that may poke holes in your opinion?
- Gambler's Fallacy: Let’s assume that the S&P has closed to the upside five trading sessions in a row. You place a short trade on the SPDR S&P 500 (SPY) because you believe chances are high that the market will drop on the sixth day. While it may happen, on a purely statistical basis, the past events don’t connect to future events. There may be other reasons why the sixth day will produce a down market, but the fact that the market is up five consecutive days is irrelevant.
- Status Quo Bias: Humans are creatures of habit. Resistance to change spills over to investment portfolios through the act of repeatedly coming back to the same stocks and ETFs instead of researching new ideas. Although investing in companies you understand is a sound investment strategy, having a short list of go-to products might limit your profit potential.
- Risk-Averse Bias: The bull market is alive and well, yet many investors have missed the rally because of the fear that it will reverse course. Risk-averse bias often causes investors to put more weight on bad news than good news. These types of investors typically overweigh safe, conservative investments and look to these investments more actively when markets are rocky. This bias can potentially cause the effects of risk to hold more weight than the possibility of reward.
- Bandwagon Effect: Warren Buffett became one of the most successful investors in the world by resisting the bandwagon effect. His famous advice to be greedy when others are fearful and fearful when others are greedy is a denouncement of this bias. Going back to confirmation bias, investors feel better when they are investing along with the crowd. But as Buffett has proven, an opposite mentality, after exhaustive research, may prove more profitable.
What Is Emotional Bias?
Emotional biases typically occur spontaneously based on the personal feelings of an individual at the time a decision is made. They may also be deeply rooted in personal experiences that also influence decision-making.
Emotional biases are usually ingrained in the psychology of investors and can generally be harder to overcome than cognitive biases. Emotional biases are not necessarily always errors. In some cases, an investor’s emotional bias may help them to make a more protective and suitable decision for themselves.
Here are a few examples:
- Loss-Aversion Bias: Do you have a stock in your portfolio that is down so much that you can’t stomach the thought of selling? In reality, if you sold the stock, the money that is left could be reinvested into a higher-quality stock. But because you don’t want to admit that the loss has gone from a computer screen to real money, you hold on in hopes that you will, one day, make it back to even.
- Overconfidence Bias: “I have an edge that you (and others) do not.” A person with overconfidence bias believes that their skill as an investor is better than others' skills. Take, for example, the person who works in the pharmaceutical industry. They may believe in having the ability to trade within that sector at a higher level than other traders. The market has made fools out of the most respected traders. It can do the same to you.
- Endowment Bias: Similar to loss-aversion bias, this is the idea that what we do own is more valuable than what we do not. Remember that losing stock? Others in its sector may show more signs of health but the investor won’t sell because they still believe, as before, it’s the best in its sector.
In general, a bias is usually the result of prejudice when choosing one thing over another. Biases can be influenced by experience, judgment, social norms, assumptions, academics, and more. Cognitive biases generally involve decision-making based on established concepts that may or may not be accurate. Emotional biases typically occur spontaneously based on the personal feelings of an individual at the time a decision is made. Emotional biases are usually not based on expansive conceptual reasoning. Both cognitive and emotional biases may or may not prove to be successful when influencing a decision.
Minimizing Unprofitable Biases
In investing, taking steps to minimize unprofitable biases can be extremely helpful in making more money.
A few examples include:
- Use a spreadsheet to calculate the risk/reward of every trade or investment. This can help in setting a threshold and never deviating from the rule.
- When you put a trade on, set an upside target. Once it reaches the target, sell the position.
One of the key ways to minimize unprofitable biases is to set objective trading rules and stick to them. Trading rules that mitigate unprofitable biases can help to override emotions and increase returns.