How to Avoid Cognitive Biases

In my last series of articles, I’ve reviewed some core cognitive biases that are constantly messing with our brains and can impair our ability to make better investment decisions. These biases are

Groupthink/Herd Behaviour

Optimism Bias

Expert Bias

Confirmation Bias

Recency Bias

Geographical Bias

We’ve seen how all of these forces and tensions, poke and prod our emotions and decision making. The big questions is, can we eliminate these behaviours or are we stuck with them?

The simple answer is No. We’re human and as such we are ALL predisposed to these behaviours and always will be. It doesn’t matter if you’re a Sage Investor or Warren Buffent or David Tepper. At some point one or likely all of these biases will come in to play.

We cannot eliminate cognitive behaviours but we can manage or control them by instilling some emotional discipline.

How to Manage Our Brain

The reality and some may say the sad, bizarre reality is we need to start thinking more like this guy.

We need to think more like George Costanza and try to take the other side of the trade. If you remember the episode, George made a life changing mood by deciding to do the opposite of what his instincts normally tell him. The result is George gets the job and the girl.

 
 

 

It sounds really really stupid and without any logic, however in investing, it appears that taking a contrarian approach and challenging conventional wisdom can go a long way to making better investment decisions. I wouldn’t go out and do what George was doing, however, certain flashpoints in the psychology of how investors behave can provide good starting points for doing some due diligence that can uncover tomorrows great investment opportunities. Below are some easy methods for managing the various biases that throw us for a loop.

Groupthink/Herding Bias: We need to avoid what the consensus or conventional thinking is on a particular stock or business event.  At the very least, we should be challenging what the consensus is saying and also we need to listen closely to what the consensus does not like as they are likely to be tomorrow’s winners. We need to avoid chasing hot trends or the “It” stock or the investment strategy flavour of the month and stick to long term first principles of investing (i.e. invest in companies and ideas that create consistent tangible wealth from the scarce capital they have been entrusted with by shareholders and are trading at a discount to their value). We need to looking out for companies and ideas that are not in vogue because chances are the market has punished them so much that the stock has become a decent entry point. I’m always looking out for companies that can demonstrate that they can be profitable when business conditions are tough, because when the pendulum turns, a great opportunity will exist to generate some meaningful returns. Dull, unsexy, and boring companies are truly gold.

Optimism Bias: We need to avoid getting immersed in just the positive of an investment opportunity. We need to seek out alternative views and perspectives. If I am researching a stock, I’m obviously interested in looking the positives in the business. (Is it profitable? Do they sell a product that people will buy again and again? Are they financially strong? Etc). I also need to be just as interested in alternative perspectives that are just as important in framing the investment decision. What are the risks the company faces in their industry? What is their competition? Is there any competition?

Expert Bias: Experts aren’t going away. We shouldn’t ignore them and we should always listen as they provide a perspective. We need to focus less on their forecasts and predictions as the research has shown they are no better than any of us in predicting the future. We should however pay close to their commentary that is critical or negative to a business concept as often those provide opportunities to uncover the diamond in the rough opportunities and a starting point for some due diligence. The best example I can think of is Apple when the stock started tanking. It felt like every analyst was pounding the table saying the company had lost its way and lost its ability to create innovative products. This after creating some of the most innovative products in history (iPhone, iPad, iPod) that were still selling millions and millions of units. It wasn’t enough for the analysts and pundits (most of whom have never run a business of their own by the way).  What happened? They came up with a watch. They upgraded their phones with new features and they still sold tons of them and at one point became the largest company in the world by market cap. If you were able to put aside the noise by the experts and focussed on the fact the company was selling 45 million phones a quarter and literally printing money, you could have bought the stock at a 30-40 percent discount.

Confirmation Bias: We need to consume and process information from sources who may not share the same value systems, beliefs and ideologies as we do. They provide perspective, context and a lot of times, a reality check. If I believe in value investing, I shouldn’t ignore insights from people who study market psychology or technical market indicators. They have nuggets of wisdom from which we can profit. Start following on Twitter or Facebook people who adopt investment strategies that are different from yours.

Recency Bias: When we invest, we are trying to make rationale, intelligent guesses about the future. As a result we need to reduce our dependence on using information of the moment as the foundation of the investment decision. If anything, we need to recognize the stories and snapshots of the moment so that we can begin looking at the alternatives. It is from there that we will find the winners of tomorrow that we seek. So if I’m seeing magazine and newspaper covers trumpeting that the stock market closed at a record high, it should act as a flag to me that the easy money has been made and that things may get a bit choppy going forward. Conversely, I watch the news and see a news reports about investors being nervous about putting money into the stock market, I’ll perk up because we could be nearing a moment where an optimal time may be at hand to slowly start building positions.

Geographical Bias: We love our homecooking. The reality is keeping a large amount of your investments domestically is not going give your portfolio the juice it needs to generate long term meaningful returns. We need to get outside our postal code and embrace the fact that business is a global organism and some of the greatest ideas do not necessarily reside in North America. Open the doors.

Easier Said Than Done

Indeed taking all of these actions in a consistent manner is not easy and it is something that you cannot just flip a switch to change your behaviours. It takes a long time and likely will come with some scrapes and bruises. It is a process. At the same time it is possible, especially if you have a network around you of resources and people that can keep you on the straight and narrow. I believe more than ever that managing these behaviors and biases is the secret sauce that can elevate our financial literacy and the level of success we need to meet our long term financial and life goals.