Even seasoned investors can fall prey to cognitive biases, i.e., little tricks the mind plays on us that can significantly impact the success of our investment efforts. But forewarned is forearmed, as the saying goes. Knowing what to look out for when investing or even when dealing with money in everyday life can help us avoid making mistakes we’ll regret down the line. The following are four cognitive biases that frequently come into play when investing.
1. The Money Illusion
Fiat money has no intrinsic value—it is only valuable for what we can buy with it. The money illusion refers to our cognitive bias to consider it in terms of nominal or face value. In the absence of inflation, that wouldn't be a problem, but money's real value or purchasing value changes over time. What you bought for a dollar as a kid is unlikely to be available today for the same price.
The existence of the money illusion has been empirically proven to affect behavior in real-world situations. For example, changing the nominal price of goods impacts demand even when there is no change in real price. People regard a nominal drop in income as unfair even when their purchasing power remains the same. At the same time, they will express satisfaction at a nominal increase even if it doesn't equate to real value and their purchasing power is reduced.
Maintaining the purchasing value of money is one of the fundamental reasons we invest our money rather than storing it under the mattress. So remember, if an investment maintains its nominal value over time, you have actually lost money in real terms.
2. The Ambiguity Effect
The ambiguity effect is a cognitive bias that leads us to avoid options for which we lack information. As humans, we dislike uncertainty and tend to make choices for which there is a known favorable outcome. Sometimes, we may even opt for a negative outcome, but one we feel we can handle. It is an adaptive response that allows us to make decisions quickly, but in the context of investing, it can be harmful to give in to it.
Investing decisions are complex and inevitably entail an element of risk. For example, there are several key unknowns in planning for retirement, such as how long we'll live, what inflation will do, and how our investments will perform. Very often, this causes people to avoid making any decision at all, or they might make the mistake of opting for low-risk, “safe” options with guaranteed but low returns.
The correct response to ambiguity in investing is to first make every effort to get answers to what you don’t know and then establish a sensible approach to dealing with risk. One option is to create high-road and low-road scenarios using extreme, opposing values. Once you know the best upside and the worst downside, you can decide where on the scale you feel comfortable taking risks. There is seldom a need to act in haste with investing, so take your time and make the right decision slowly rather than the wrong decision quickly.
3. The Bandwagon Effect
The bandwagon effect is a cognitive bias that refers to our tendency to follow public opinion or our peers’ behavior when making personal choices regardless of the underlying evidence. It's where the expression "hop on the bandwagon" comes from, and it is also an adaptive response. Humans are social creatures, so the influence of other people can easily affect our decision-making processes.
The phenomenon is also known as herd mentality or groupthink, and it can be dangerous in the investment context for two main reasons. First, investment decisions are not a uniform fit; what is right for one individual may not be right for another. Second, we cannot rely on people to act rationally—the "herd" could well be falling prey to any number of cognitive biases.
4. Confirmation Bias
Confirmation bias is the tendency people have to gravitate toward information that supports their existing beliefs. It can be an efficient way to process information and reduce our stress while also feeling good about how clever we are. But, falling prey to this bias in investing means we can miss out on new opportunities or ignore valuable information that would otherwise warn us against specific actions.
Instead, savvy investors actively question their beliefs and rely on data rather than preconceived ideas and emotions to make investment decisions. Create a routine that will expose you to contrary viewpoints, such as reading a wide variety of news media, and remain disciplined about basing decisions on evidence.