Six Cognitive Biases Messing with Your Investments

By Jack Hagedorn

March 8, 2019

Six Cognitive Biases Messing with Your Investments

Our brains are incredible instruments. We’ve built spaceships that have gone to the moon, condensed the entirety of human knowledge into handheld devices, and turned burritos into bowls.

While our brains are extremely advanced, there are still some blind spots from the times when we were hunters and gatherers. These blind spots are called ‘cognitive biases,’ and they do this funny thing where they change our perception of reality to help us maintain a coherent sense of self.¹ If you’ve ever heard someone double down on their position after an argument, you’ve seen a cognitive bias (The Backfire Effect) in action.²

When it comes to investing, these cognitive biases can affect our strategies in ways we’re not aware of. Below are six examples of cognitive biases and how they might be affecting your investment strategies.

Declinism

Declinism is a cognitive bias that tells us the past was great, and the future will be miserable. It’s a mechanism to help gravitate towards familiarity, because what’s been safe in the past has gotten us to where we are today.

If you ever turn on CNBC for like three seconds, you’ll immediately see this in action:

“There is almost certainly a recession imminent.”
“This downturn will be worse than the past ones.”
“Today’s markets are nothing like our parents’ markets.”

The reality is that the future will likely play out in a similar way as the past. Twenty years from now, some good things will have happened, some bad things will have happened, and Keanu Reeves will still look exactly the same.

Confirmation Bias

Confirmation Bias is our brain’s tendency to seek out information that confirms our beliefs. If I believe that bees are responsible for an over-abundance of plastic in our oceans, I will go out and find articles that reinforce the evilness of bees.

We are all guilty of seeking out information to validate our beliefs - it’s part of maintaining a healthy sense of certainty about reality. Knowledge goes under our belts, and we understand the world a little better.

However, the Confirmation Bias becomes harmful when we seek to reinforce our beliefs about a strategy that’s not working, convincing ourselves that it “just needs some more time.” At that point, we need to take a step back and decide whether the underlying decision is based in reality, or if it is a sunk cost.

Part of a healthy mind is seeking out new opinions and perspectives, and adding different perspectives to your investing toolkit will add to your depth as an investor.

We are all guilty of seeking out information to validate our beliefs - it’s part of maintaining a healthy sense of certainty about reality. Knowledge goes under our belts, and we understand the world a little better.

Empathy Bias

The Empathy Bias underestimates the power that feelings and emotions have on a decision. Humans have an amazing ability to warp logic and facts to fit their emotional states, justifying any decision with logic (afterward).

This helps us keep a stable sense of self, because if (when) we act on emotion, we still need to perceive ourselves as rational individuals who have a reason behind doing something. This is also why asking “why?” automatically triggers a justification response - because our brains can justify anything.

Take Bitcoin for example. In 2017, it was a very cool fad to buy and have Bitcoin and other cryptocurrencies. And while I will stay away from commenting on the underlying potential of cryptocurrency, it is very clear that much of the hype surrounding Bitcoin was simply that - hype. People continued to buy Bitcoin because they were emotionally invested in the fad, and did not want to miss out on the next great opportunity. We saw how that played out.

It can be easy to get swept up in a fad like Bitcoin or investing in tech during the 2001 Tech Bubble because emotions are powerful, and emotions drive us to take action. When you’re faced with an investment decision, make sure to acknowledge the role your emotions play in the decision, because they may be driving you to make the decision more than you think.

Pro-innovation Bias

The Pro-innovation Bias is excessive optimism about innovative/new technology and its effectiveness. It’s absolutely normal to get excited (see: Bitcoin) about an incredible future, but tomorrow’s Robot Maid “Rosie” will not bring us fully into the world of the Jetsons.

When Google Glass was announced in 2014, people were ecstatic about the potential it held. Augmented Reality (AR) was going to turn everyone’s day-to-day life into a Tony-Stark-Iron-Man experience. However, the program, in its nascency, may have been too ahead of its time. People who bought the Google Glass experienced a limited version that fell far short of its expectations.

What this teaches us is that not every technology is going to be “the next big thing” on its first go-around. Touchscreens were around years before Steve Jobs released the first version of the iPhone.

For investing, we’re going to see an increased pace of development - rapid technology development that will create new opportunities and certainly a lot of hype. AR, VR, and A.I. are two-letter hot topics that will generate a lot of buzz. Not every company is going to make it through the initial hype phase, and choosing where and when to invest will be important.

Semmelweiss Reflex

The sixth cognitive bias is the Semmelweiss Reflex, which is the tendency to reject new evidence that contradicts an established paradigm. Think of Giordano Bruno being burned for proposing that Earth actually revolves around the sun.

Humans are extremely good at adapting to new environments, but cognitively, we are somewhat resistant to change, especially when it contradicts what we have been taught.

My favorite quote of all time is by Charles H. Duell, Commissioner of the U.S. Patent office in 1899. His legendary quote is:

“Everything that can be invented has been invented.”

Needless to say - he was a little off.

Along this same line is the idea that the now “best” investment approach out there will remain the best investment approach forever. We live in tumultuous times, and there will likely be a better investment philosophy created by investment management experts. The question is how long it might take for a new philosophy to be adopted and advocated by investment professionals - and what kind of advantage an early adopter of this philosophy might have.

Overcoming our cognitive biases requires us to be conscious of what they are. Studies show that cognitive biases can be mitigated when we’re aware of their effect. When we’re making investment decisions, it’s important to consider that there may be times when our biases cloud our judgment. In overcoming these cognitive biases, we can empower ourselves to make more logical, grounded investment decisions.

^{1. The Evolution of Cognitive Bias, Haselton et al., 2014. The Evolutionary Psychology Handbook, 2nd Edition, Wiley.}

2. https://en.wikipedia.org/wiki/List_of_cognitive_biases

Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.

March 8, 2019

Six Cognitive Biases Messing with Your Investments

Our brains are incredible instruments. We’ve built spaceships that have gone to the moon, condensed the entirety of human knowledge into handheld devices, and turned burritos into bowls.

While our brains are extremely advanced, there are still some blind spots from the times when we were hunters and gatherers. These blind spots are called ‘cognitive biases,’ and they do this funny thing where they change our perception of reality to help us maintain a coherent sense of self.¹ If you’ve ever heard someone double down on their position after an argument, you’ve seen a cognitive bias (The Backfire Effect) in action.²

When it comes to investing, these cognitive biases can affect our strategies in ways we’re not aware of. Below are six examples of cognitive biases and how they might be affecting your investment strategies.

Declinism

Declinism is a cognitive bias that tells us the past was great, and the future will be miserable. It’s a mechanism to help gravitate towards familiarity, because what’s been safe in the past has gotten us to where we are today.

If you ever turn on CNBC for like three seconds, you’ll immediately see this in action:

“There is almost certainly a recession imminent.”
“This downturn will be worse than the past ones.”
“Today’s markets are nothing like our parents’ markets.”

The reality is that the future will likely play out in a similar way as the past. Twenty years from now, some good things will have happened, some bad things will have happened, and Keanu Reeves will still look exactly the same.

Confirmation Bias

Confirmation Bias is our brain’s tendency to seek out information that confirms our beliefs. If I believe that bees are responsible for an over-abundance of plastic in our oceans, I will go out and find articles that reinforce the evilness of bees.

We are all guilty of seeking out information to validate our beliefs - it’s part of maintaining a healthy sense of certainty about reality. Knowledge goes under our belts, and we understand the world a little better.

However, the Confirmation Bias becomes harmful when we seek to reinforce our beliefs about a strategy that’s not working, convincing ourselves that it “just needs some more time.” At that point, we need to take a step back and decide whether the underlying decision is based in reality, or if it is a sunk cost.

Part of a healthy mind is seeking out new opinions and perspectives, and adding different perspectives to your investing toolkit will add to your depth as an investor.

We are all guilty of seeking out information to validate our beliefs - it’s part of maintaining a healthy sense of certainty about reality. Knowledge goes under our belts, and we understand the world a little better.

Empathy Bias

The Empathy Bias underestimates the power that feelings and emotions have on a decision. Humans have an amazing ability to warp logic and facts to fit their emotional states, justifying any decision with logic (afterward).

This helps us keep a stable sense of self, because if (when) we act on emotion, we still need to perceive ourselves as rational individuals who have a reason behind doing something. This is also why asking “why?” automatically triggers a justification response - because our brains can justify anything.

Take Bitcoin for example. In 2017, it was a very cool fad to buy and have Bitcoin and other cryptocurrencies. And while I will stay away from commenting on the underlying potential of cryptocurrency, it is very clear that much of the hype surrounding Bitcoin was simply that - hype. People continued to buy Bitcoin because they were emotionally invested in the fad, and did not want to miss out on the next great opportunity. We saw how that played out.

It can be easy to get swept up in a fad like Bitcoin or investing in tech during the 2001 Tech Bubble because emotions are powerful, and emotions drive us to take action. When you’re faced with an investment decision, make sure to acknowledge the role your emotions play in the decision, because they may be driving you to make the decision more than you think.

Pro-innovation Bias

The Pro-innovation Bias is excessive optimism about innovative/new technology and its effectiveness. It’s absolutely normal to get excited (see: Bitcoin) about an incredible future, but tomorrow’s Robot Maid “Rosie” will not bring us fully into the world of the Jetsons.

When Google Glass was announced in 2014, people were ecstatic about the potential it held. Augmented Reality (AR) was going to turn everyone’s day-to-day life into a Tony-Stark-Iron-Man experience. However, the program, in its nascency, may have been too ahead of its time. People who bought the Google Glass experienced a limited version that fell far short of its expectations.

What this teaches us is that not every technology is going to be “the next big thing” on its first go-around. Touchscreens were around years before Steve Jobs released the first version of the iPhone.

For investing, we’re going to see an increased pace of development - rapid technology development that will create new opportunities and certainly a lot of hype. AR, VR, and A.I. are two-letter hot topics that will generate a lot of buzz. Not every company is going to make it through the initial hype phase, and choosing where and when to invest will be important.

Semmelweiss Reflex

The sixth cognitive bias is the Semmelweiss Reflex, which is the tendency to reject new evidence that contradicts an established paradigm. Think of Giordano Bruno being burned for proposing that Earth actually revolves around the sun.

Humans are extremely good at adapting to new environments, but cognitively, we are somewhat resistant to change, especially when it contradicts what we have been taught.

My favorite quote of all time is by Charles H. Duell, Commissioner of the U.S. Patent office in 1899. His legendary quote is:

“Everything that can be invented has been invented.”

Needless to say - he was a little off.

Along this same line is the idea that the now “best” investment approach out there will remain the best investment approach forever. We live in tumultuous times, and there will likely be a better investment philosophy created by investment management experts. The question is how long it might take for a new philosophy to be adopted and advocated by investment professionals - and what kind of advantage an early adopter of this philosophy might have.

Overcoming our cognitive biases requires us to be conscious of what they are. Studies show that cognitive biases can be mitigated when we’re aware of their effect. When we’re making investment decisions, it’s important to consider that there may be times when our biases cloud our judgment. In overcoming these cognitive biases, we can empower ourselves to make more logical, grounded investment decisions.

Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.