Understanding How The Cognitive Biases Can Mislead Us When Investing

Investing is often seen as a numbers game, involving comprehensive fundamental and technical analysis, deep research, strategy, and many sleepless nights. At least, that's how it should be. We all have access to the same information, the same analysts' reviews, and the same books. Why, then, don’t we achieve the same returns? Why does our portfolio performance differ from one another? The simple answer to these questions is emotions. A more complex answer is cognitive biases.

These biases impact our decisions and, as a consequence, our investing performance. Understanding them and their impact can help you make better, more rational decisions. In this post, we will explore the most common cognitive biases and discuss how these biases can affect your investment behaviour.

One of the most well-known biases is overconfidence. At least once in our life we overestimated our skills, the knowledge we possess, ability to predict future events. In investing, this tendency can lead to overestimating our knowledge and understanding about markets, companies, financial statements, economic trends, market trends, technical analysis and many more aspects of investing.

There are three main consequences of the overconfidence bias: excessive trading, risk ignorance and misjudging the stock-picking ability. All of these can negatively impact investments and portfolio performance. How?

When we are overconfident, we tend to act more frequently on that belief. This happens when we are overconfident about our knowledge and skills of the financial markets. We may overtrade, believing that we can time the market. But the truth is, no one can.

Numerous studies by the world-renowned investors, including John Bogle (the “father” of index investing and founder of Vanguard) and many business schools have reached the same conclusion – frequent trading generally leads to underperformance due to higher transaction costs and taxes. Some might argue that “commission free” and “no fee investing” (platforms like Robinhood and Trading 212 offers this) negate this issue.

However, excessive trading still for incurs costs, especially in foreign investments where foreign exchange (FX) rates apply. Overconfident investor, may ignore the risk assuming they have superior market insight. This often leads to taking excessive leverage - borrowing more and more from your broker (IG Trading offers spread-betting and CFD products based on leverage), to be able to purchase more and more shares. This results to overconcentration, which is the second problem here. When trade using leverage, we can maximise profits as we borrow to buy more stocks. This is all good if stock prices go up. If prices go south, we can lose even more than our initial capital.

Overconcentration in specific stocks occurs when an investor is overconfident about a stock and keeps purchasing more, believing its price will eventually return to their average purchase price. This may sound like dollar-cost-averaging strategy (or pound). However, it is not. We usually end up having an 80-90% concentration of our portfolio in one or two stocks, resulting in substantial losses.

Misjudging their stock-picking abilities is another consequence of overconfidence. Yes, overconfident investor believes that he or she can consistently pick winning stocks. For example, investing in Nvidia in January, 2023 and achieving over 500% return of a single investment is great.

However, this doesn’t make you Warren Buffett or Peter Lynch. The overconfidence after once winning stocks can fuel confidence, but this often leads to underestimation of the value of diversification. Example of overconfidence in action. An investor might think they can predict the movement of a volatile stock based on recent news and trade excessively. However, the complexity of the market and its randomness often challenge short-term prediction, leading to loses.

Cognitive Biases

Anchoring is another cognitive bias that often occurs when we invest. The “anchor” refers to the first piece of information we encounter when making an investment decision.

Anchoring happens when we become overly dependent on this information. The anchor could be the initial stock price, a past high, or a target price. Anchoring negatively affects our investments. How? By causing us to either stick to outdated data or set unrealistic targets.

Investors may cling to the initial price they paid (the "anchor") or a past peak, even when that data becomes outdated. The fundamentals may have changed, and the stock might never reach that price again. This often prevents investors from selling underperforming stocks.

On the other hand, anchoring also influences the price at which investors are willing to buy or sell. For example, they might refuse to buy or sell a stock until it reaches a specific target price, even if that target is no longer realistic. An example of anchoring in action: An investor buys a stock at £100, but the price falls to £50. They may hold onto the stock, hoping it will return to £100, regardless of worsening fundamentals. This is an example of anchoring bias, leading to ineffective decision-making.

Confirmation bias is the tendency to search for information that confirms what we already believe about a particular stock. Many investors tend to interpret and recall information in a way that supports their pre-existing beliefs. Moreover, this often leads to ignoring contradictory information and overstating any data that supports their viewpoints.

There are three ways that confirmation bias can affect our investments: selective attention, ignoring red flags, and reinforcing poor investment decisions. Selective attention, means that investors focus only on information that supports their viewpoint, disregarding any contradictory information that suggests market or stock may be underperforming.

For example, you heard about next “meme stock” (e.g. GameStop) from Reddit or by watching a video on YouTube and you believe now is the moment to investment in that stock. You then start looking only on at positive reviews and analysis that confirm your viewpoint.

Conversely, you may avoid any negative analysis or reviews about the stock. Furthermore, confirmation bias can drive investors to neglect negative earnings reports, market trends or news, hoping that the stock will recover as it aligns with their existing narrative. For instance, many investors are hoping that their 90% losing position on a specific stock will recover back to the initial purchase price, ignoring all the negative news or releases by that particular stocks.

The fundamentals have changed, but the investor is still “hoping” for recovery as they continue to believe in outdated information and fundamentals. Confirmation bias reinforces the poor investment decisions. How does this happen? An investor keeps investing in poorly performing stocks because he/she is searching out for news or analysis that suggests the stock will eventually recover.

Example of confirmation bias in action. For instance, an investor who is bullish on a technology stock focused on AI only pays attention to positive news about the company’s growth prospects, while ignoring the reports of slowing earnings or increased competitions in the AI sector.

Studies have shown that the pain of losing money is psychologically more significant for the brain than the pleasure of making money. Loss-aversion is the tendency for investors to prefer avoiding losses rather than acquiring equivalent profits. How does loss-aversion affect investors?

There are three consequences of this bias: holding onto losing stocks, avoiding risk, selling winners too soon. Loss-averse investors act irrationally. They tend to hold onto losing positions for too long, hoping they will recover, instead of cutting their loses and use the funds to invest in better-performing stocks.

The fear of losing money affects everyone. The feeling of losing money is unique and can prevent investors of closing a losing position. Loss-aversion can cause an investor to avoid risks and become a risk-cautious.

Consequently, their portfolio tends to be conservative and these types of investors are missing out growth opportunities. Loss-aversion investors also sell their winners too soon. After weeks, months and even over a year a losing position may finally turn green and be profitable. This is when loss-aversion investors are selling quickly their position and to lock in profits. The limitation is that they may miss out on even more gains as the stock could have further growth potential. Example for loss-aversion in action. An investor who bought a stock at $100 and sees it drop to $50 might refuse to sell it even if the fundamentals have changed. He/she would rather hold the stock and avoids the emotional pain of realising a loss than selling and moving to a better investment.

Cognitive biases

Recency bias can cause overreaction to short-term market fluctuations ignoring the larger picture. This bias drive investors to weight recent events more heavily than the broader picture. Recency bias affects investors by: overreacting to market news, chasing trends, overvaluing recent performance.

Overreacting to short-term price movements may lead to rash decisions among investors and cause them to overlook broader market patterns. For example, after a bad quarterly earnings results and a short-term sale of a stock an investor may decide close his position, ignoring the long-term picture.

Recency bias can lead to pursuing market trends or “hot” stocks. As investors believe that this trend will last indefinitely. An investor may also overvalue the recent performance. He/she may mistakenly assume that this recent performance is suggestive of it is long-term outlook, causing buy or sell at the wrong time.

For instance, an investor sees his position at GME is double for two days (because of memes stocks craziness). Now he is assuming that this trend will continue in future. Unfortunately, after few days his position is down by 90%...  A real story!

Example of recency bias in action. The situation: there is a sharp drop in the market. An investor might panic sell off their positions, ignoring the fact that the market has historically rebounded after declines.

Herding behaviour bias has always been present. However, since the pandemic, it is popularity has increased enormously, thanks to platforms like Stocktwits, Reddit and YouTube. What is herding behaviour?

This bias refers to the tendency for individuals and investors to follow (“copy” in investing) a larger group of people or the “herd”, under the believe that the herd knows something they do not. In investing, this can manifest as reaction to popular opinion (after watching couple of YouTube videos) or following the market trends without proper due diligence. Herding behaviour affects the investors by leading to actions like chasing popular stocks, panic selling and missing opportunities.

Investors may chase popular stocks, which can lead to maintaining of a portfolio built of stocks with high media attention, even when these stocks may be overvalued or do not align with their personal investment strategy. In declining market, herding can lead to “following” the crowd and panic selling, causing investors to close their positions, as they do not act rationally or trust their strategy.

When investors are too focused on following the crowd, they often miss out on investment opportunities in stock that are not under-the-radar.

 Example of herding behaviour in action. The 1990s dot-com bubble is a classic example. Investors were rushing to buy any tech stocks (or anything with “.com” in the name), simply because others did so (or recommended doing so), ignoring the fundamental valuation metrics. We all know the outcome: the bubble burst.

Hindsight bias can lead to overconfidence and alter an investors perception of their judgement abilities. This bias is the tendency to see events as having been expectable after they have already occurred. Hindsight bias affects the investors by causing them to overestimate their foresight and learning the wrong lessons. Investors may believe they” knew” a stock would perform well after an upside move.

This leads to overrating their predictive ability and becoming overconfidence in future decision-making. One successful investment does not make you Warren Buffett.

Overconfident investors often think they know the market and it is behaviour based on past experiences. That is why hindsight bias can cause investors to learn the wrong lessons from market events. Example of hindsight bias in action. As described, this bias leads to overconfidence in investors abilities to predict future market movements. Investors claim they “knew” a market crash or upside trends is coming after the fact, when in reality, forecasting the market in real time is very difficult.

The last but not the least, availability bias occurs when investors trusts immediate examples that comes to mind easily when evaluation a decision. This can lead to overstressing recent or memorable data over more comprehensive one.

Availability bias affects the investors by causing them to basing decision on recent news and ignoring long-term trends. Investors might rush investment decisions based on the most recent news stories, rather than conducting a thorough due diligence of a company long-term performance or industry trends.

Availability bias can lead to overlooking long-term market or economic trends in favour of overreacting to recent events. Example of availability bias in action. For example, an investor is hearing a lot of media coverage about Soundhound (SOUN) as next big AI play. An investor might decide to buy it without conducting research of SOUN financial health or long-term prospects.

In conclusion, cognitive biases can cause significant impact on the investments decision-making. By recognising these biases and actively managing them, investors can make more well-versed and rational decisions. By understanding these biases, investors can improve their long-term financial results.

At Concord Capital Intelligence, our advisors are here to help you navigate these biases and make knowledgeable and rational decisions. Reach out to us today to discuss your investment objectives and optimise your portfolio for long-term success. Let’s work together to ensure you investments future is built on comprehensive strategies, not impulsive reactions.