4 More Cognitive Biases Investors Must Guard Against to Protect Their Investments
Emotionally intelligent investors tend to be more successful than investors who lack introspection and empathy. That's partly because their habits of observation and inquiry enable them to better predict behavior in others. But a large part of it is because they "know themselves" and the cognitive biases all of us are subject to. The following are four biases that investors should familiarize themselves with to avoid falling into the unconscious "traps" our minds can set up for us.
1. Endowment Bias
Endowment bias refers to the tendency to over-value something we already possess. It generally asserts itself in an unwillingness to give up something we own even if we will improve our financial situation by doing so. Or, we may demand more to give it up than we would pay to acquire it. Endowment bias, also known as divestiture aversion, most frequently occurs when we associate with the object emotionally (for example, something left to us by a beloved relative or the home where we've raised our family).
Sometimes there can be valid reasons to hang onto assets for non-financial reasons. We may wish to pass onto our children an asset that has passed from generation to generation within our families. Items such as family bibles, art, and jewelry may fetch more than we would pay for similar items belonging to strangers, but they have a unique value to us.
For most individuals, their house is their most valuable asset, but it can also be the asset we are most emotionally attached to, with the least sense. With this and other assets, analyze the pros and cons of retaining such a significant investment. Are you staying to avoid the relatively minor hassle of moving? Are you anxious about losing neighbors you could easily still visit? Are you placing an accurate value on the alternative, such as living somewhere that’s more convenient, more suited to your needs, more affordable, or a better investment?
2. The Disposition Effect
Many cognitive biases come into play in multiple areas of life, but the disposition effect is specific to investing. It refers to an observed reluctance on the part of people to sell assets that have depreciated since they were acquired and a preference to sell appreciated assets. Several studies have found that people dislike losing more than they like winning. Faced with two options that result in the same economic effect, individuals will choose the option with possible gains over one with potential losses.
Being aware of the disposition effect is the first step in countering it. Ensure you are basing decisions on evidence rather than intuition. You can also practice hedonic framing, whereby you counter disposition bias by splitting gains into smaller units to strengthen their effect or combine losses to weaken their effect. So, instead of focusing on the loss you've made on a depreciated asset, concentrate on the many benefits of selling it, such as the potential profit on a replacement investment, the reduced anxiety and feelings of regret, possible tax benefits, and so on.
3. Present Bias
Present bias is a cognitive bias that places greater store on events closer to the present than future events. We all know how hard it can be to deny ourselves pleasures today to save for the future. Walter Mischel’s famous marshmallow test formally studied the concept of delayed gratification in children and the impact that impulse control (or the lack thereof) had on their lives down the line.
In the test, children were given the choice to either eat a single marshmallow immediately or wait for 15-20 minutes to get two marshmallows. Follow-up research showed that the children who elected to delay gratification and wait for the two treats were the ones that turned out to be more successful later in life. Sometimes small decisions now can make a big difference to our lifestyles in the future. Investors who develop strong patterns of self-discipline will inevitably be rewarded.
4. Status Quo Bias
Deciding on a new course of action requires mental effort, and our brains are designed to be as efficient as possible. Status quo bias refers to the tendency to adhere to a current course of action or pattern of behavior rather than apply our minds to change it. It isn’t the same as selecting a default choice—defaults are deliberately chosen, considered choices we have “at the ready” for when we need to act expediently and genuinely don’t have time to think.
To overcome status quo bias, remind yourself that good things don't come easy and that life begins at the edge of your comfort zone. Then, to make change more palatable and manageable, break the process into small sub-tasks that are less overwhelming. Next, identify the potential obstacles and develop a plan for how you will overcome them. And finally, remind yourself of past occasions where you have made significant changes that have turned out well.