The Hidden Traps in Investment Thinking

The psychology of investing is a deep and interesting study that seeks to understand our attitudes, beliefs, values, and decision making in our investment portfolio. When I first started at United Capital Financial Advisors, there was an informative practice using cards to select and identify what values were prioritized by the investor. Each card had a topic to help the advisor and the client discover what was important to them. Cards would have statements illustrating a desire to limit taxes, contribute to charitable causes, or other similar financial goals. Each card was associated with a Money Mind, grouped as either Fear, Protection, or Happiness and it helped clients understand what financial goals they might have.

Little did I know at the time, that this was merely the tip of the iceberg to behavioral finance. The field actually extends further into the various pitfalls investors have in their reasoning to justify an investment decision. Subjectively, most people are familiar with the emotional roller-coaster associated with risk-prone investments; however, there are actually numerous cognitive errors and illusions that managers and investors experience on a frequent basis. For today's reading only, here are Five Cognitive Errors to think about when making an investment decision.

Five Cognitive Errors for Investment Thinking

The Great Money Illusion

Is a dollar today really worth a dollar tomorrow? Definitely not. This is because of the power of inflation. You may have heard already, but, cash savings is generating huge interest for today's investors. Money Market positions earning nearly 5% interest annually. This, in fact, is the great illusion itself, because after inflation, that 5% interest is really only 1-2% in real return.

Lets use a $1,000 savings account as an example. If this account, after one year, generates $50 in interest (5%), then the account is worth $1,050; however, if the price of goods and services rose 4%, meaning the same goods and services previously worth a $1,000 now cost $1,040, then your real net gain was only $10 or 1%. The purchasing power was eroded almost entirely.

So which is really more appealing? A 3% return with no inflation or a 6% return with 4% inflation? Hopefully this illusion plays less tricks on us in the future.

Conservatism Bias

Consider how much news we absorb explaining the latest events of different companies and firms on Wallstreet. Now think about how often that news has shaped your perspective. Traditional finance theory asserts that individuals generally make rational decisions regarding their investments, but how quickly does our perspective change at the onset of new information? I'll wager it changes quicker when the news is positive, but less so when negative.

Consider the impacts of the digital camera during the age of Kodak. This firm held closely to their film-based product during the emergence of the digital camera, a technological replacement. Investors who continued to anchor onto the idea that film photography would persist in use and popularity likely had difficulty embracing the change and shift in technology adoption. The result - holding an investment too long, or perhaps too late. The problem here, was the inability of investors to change their perspective with new information.

Outcome Bias

Ever select a fund to invest in purely because of their historical three-year performance? The tendency to rationalize a decision based on historical outcomes is probably a lot more frequent than you might think. This simplistic belief that a fund or stock's performance will continue to rise without considering the economic conditions under which it performed. Effectively - there is no solid fundamental application of decision making beyond "its outcome."

Framing Bias

This cognitive bias is a little difficult to identify because its the assertion that a given frame of reference (beliefs, conditions, facts) impacts an investors decision making. This means individuals will process and respond to information based on the manner in which its presented, compared with similar scenarios, particularly from the perspective of Gains or Loses.

Consider how you might respond when presented with two investment options:

• Fund A has a 90% chance of success

• Fund B has a 10% chance of failure

Which fund do you choose? It shouldn't matter, because they are both identical, yet they are framed differently. Under this bias, individuals may lean towards one or another option depending on their attitudes towards risk and performance.

Recency Bias

Remember when Wells Fargo ($WFC) was caught in the scandal of opening fake accounts? How often do you think this event factors into the decisions made by investors to continue to invest in Wells Fargo today? Probably not at all, but at the time of the news, Wells Fargo stock declined over 10% in the weeks following. Since the scandal has released, the stock has experienced a total return over 60% from its Oct 2016 low of $43.55 per share. Was the recent information more valuable than prior information?

Another more recent event occurred with CrowdStrike ($CRWD), the recent news of a software update causing disruption across computer systems worldwide was considered more valuable information than the importance and continued use of its product globally. Today, CrowdStrike still stands as an important cyber-security firm that is utilized by many organizations worldwide.

How do we use this?

It starts with becoming more self-aware. The detail that should be most pertinent about these hidden dangers, is that these are not emotionally driven decisions, they are logical errors and fallacies in our thought process. Catching them in the act, and pivoting will make a huge difference behind poor investment decisions. Hopefully, with time and commitment, avoiding cognitive bias will become easier.