Introduction

From an investment perspective, almost every decision is inevitably influenced by various cognitive biases. These are defined as ‘systematic patterns of deviation from norm or rationality in judgment’ and can negatively affect future investment judgements and valuations. Devina Mehra, founder and chairperson of First Global, a leading Indian and Global Investment Management firm, found that, "These biases are hardwired into our brains and are the result of thousands of years of evolution where they served a purpose. Evolution is frankly not interested in our portfolio or investments, its only focus is on our survival and procreation.” She emphasises that although it is important for investors to understand how to ‘beat’ cognitive biases, these are still almost impossible to completely eliminate, except through a system. She found that ‘Being conscious of them and by putting certain rules in place, you can somewhat reduce the impact for a handful of those biases”

Am I Making the Wrong Stock Investing Moves?

Do you often lose money? Do you have an impulsive drive to make it back twice as fast? Why? This is because of a cognitive bias also known as Anchoring and Adjustment. It is defined from an investment perspective as a two-stage process of judgement, in which the purchase price of the initial investment and the expectations for its returns are subconsciously picked as the anchor, and then this reference point is adjusted for future investment judgements and valuations. However, the anchor is sensitive to context, and the adjustment may be insufficient. Anchoring and Adjustment mean that seemingly irrelevant cues can affect future investment judgements and valuations, and this manifests itself in different ways.

Example

For example, consider a small-cap stock which is bought at Rs50 and is expected to double in value over two years, which instead drops to Rs25. An average investor would have already subconsciously picked the expectation of Rs100 as an anchor for their future investment judgements and valuations. Therefore, it is to be expected that they would seek investment opportunities that are expected to quadruple in value, instead of double in value. What’s happening here is the self-inflicted compounding of bad investment decisions and valuations and an increase in exposure to risk with unrealistic expectations. Again, this is because seemingly irrelevant cues can affect future investment judgements and valuations.

How to Recognise Biases

The CFA Institute found, in its Field Guide of the Behavioral Biases of Individuals, that there are two types of biases:

Emotional Biases

An emotional bias is defined as a “distortion in cognition and decision-making due to emotional factors”. Again, it is to be expected that the average investor would be influenced by the anticipation of specific emotions as a result of the consequences of an investment decision. For example, consider an investor who is deciding whether to move some of their money into a risky high-tech stock. One of the consequences of this investment decision could be losing money. Therefore, the investor is influenced by the anticipation of regret as a result of the investment decision, and the desire to avoid experiencing regret may help to dissuade them from investing. An emotional bias affects investment decision-making in two ways:

1. An emotional bias can influence a decision directly, as previously mentioned. For example, if the investor above is influenced by the anticipation of regret as a result of the investment decision, as well as immediate anxiety at the thought of moving some of their money into a risky high-tech stock, this will dissuade them from investing. This is also known as an anticipatory influence.

2. An emotional bias can influence a decision indirectly, by affecting future investment judgments and valuations. For example, if the investor above is influenced by immediate optimism about the investment decision and its consequences, this will persuade them to invest. This is also known as an incidental influence.

How to Beat It

From an investment perspective, it is more difficult to beat an emotional bias than a cognitive bias because it is almost impossible to ‘switch off’ any emotional response as a result of losing or making money.

Cognitive Errors

A cognitive error is defined as stemming from a mistake in processing or recalling information, and there are two types:

1. A belief perseverance is defined as the tendency to maintain an existing belief, even when there is new information that firmly contradicts it. This is because the average investor is expected to be selective to new information, in terms of exposure, perception, or retention.

2. A processing error is defined as the tendency to make a bad decision because of a mental shortcut, and there are three related biases:

1. An overconfidence bias is defined as the tendency to assign inflated probabilities to hypotheses.

2. A confirmation bias is defined as the predisposed tendency to maintain an existing belief when there is new information that supports it.

3. A recency bias is defined as the tendency to favour recent events over historic events.

How to Beat It

From an investment perspective, the good news is that it is easier to beat a cognitive bias than an emotional bias, because a cognitive error represents the natural limits of the human mind, rather than emotional responses. An investor should understand that since they stem from mistakes in processing or recalling information, and overconfidence in their ability to beat the market itself, this type of bias often leads to bad investment decisions. Some strategies to beat these biases include:

Be Self-Aware

It can be argued that undertaking thorough research and analysis - and reading this report - to understand that biases are a part of investing, is the best way to beat cognitive errors.

Resist the Urge to Trade

For example, it can be difficult to resist the urge to trade when faced with new information. However, the Indian investor should understand that if this ‘new’ information was from an open-access source, such as Barron’s or CNBC, then it is instead widely known information. It can be argued that trading on open-access information does not lead to market-beating performance, and so they are better off resisting the urge to trade. Furthermore, any increase in trading driven by cognitive errors can erode returns because of transaction costs and taxes.

Seek Diverse Perspectives

These can help to beat biases by improving overall investment strategy. It is also important to have a devil’s advocate. This could be a friend, family member, or financial advisor. An ideal devil’s advocate should double-check investment judgements, valuations, and decisions, and identify strengths as well as weaknesses. On the other hand, act as a devil’s advocate for somebody else who is seeking diverse perspectives.

Loss Aversion

A loss aversion is when losses are disliked more than gains are commensurated. Mehra found that “In the markets, it means that a Rs 1 lakh loss will make us far more unhappy than the happiness we may find in a Rs 1 lakh profit,”. From an investment perspective, this can prevent investors from admitting mistakes and cutting losses in the stock market. As previously mentioned, this is because it has evolutionary roots in survival and procreation, where they served a purpose which was crucial for survival.

How to Beat It

Mehra found that it is important to put “a ‘stop-loss’ system in place and be disciplined about sticking to it; not making excuses if a stock hits a ‘stop-loss’ limit,” Again, although it is important for investors to understand how to ‘beat’ cognitive biases, these are still almost impossible to completely eliminate, except through a system. “If you want to buy stocks with specific characteristics, put that as a system and then actually buy all the stocks that meet those criteria,”.

Herding Behaviour

Herding behaviour is the behaviour of individuals in a group acting collectively without centralised direction. Again, this is because it has evolutionary roots in survival and procreation, where this served a purpose which was crucial for survival. Mehra found that from an investment perspective, the increase in new fund offerings, including thematic options like Nasdaq ETFs, small-cap funds, and industry-specific funds, exploit this natural instinct to follow the crowd.

How to Beat It

Avoid Thematic Funds

One of the main ways to beat biases caused by herding behaviour is to avoid thematic funds. Mehra found that “If you want to get over it, remember there is no need to have the fear of missing out (FOMO) as opportunities are like buses - if you miss one, the next one will come along,”. She emphasises that the entire thematic fund business is predicated on the desire of human beings to jump on whichever bandwagon everyone else is getting onto, and to consciously avoid thematic funds.

Keep Investments Private Initially

Another way to beat biases caused by herding behaviour is to keep investments private initially. This means limiting discussions about them. Mehra found that investors should “not discuss them in person or on WhatsApp or Telegram groups, not at least until you have done your own analysis and come to your own conclusions.

How Can I Make the Right Stock Investing Moves?

Slow down.

From an investment perspective, the benefits of an increase in the time spent collecting information to make an investment decision often outweigh the consequences and lead to better outcomes. Sometimes, the best thing to do is nothing at all.

Have a Systematic Approach to Decision-Making

Again, it is important for investors to undertake thorough research and analysis to understand that biases are a part of investing. Perhaps keep an investment journal to document and double-check investment judgements, valuations, and decisions, and identify strengths as well as weaknesses before they happen. The journal should have clear subsections to highlight areas where investment decisions are most influenced by biases.

Use Artificial Intelligence

Mehra is an advocate of the strategic use of artificial intelligence to beat biases caused by the natural limits of the human mind. She emphasises that a well-designed system will outperform so-called human experts. This is because both cognitive biases and random noise will exist wherever there is human judgment.

Conclusion

In conclusion, it is clear that cognitive biases are an inevitable part of almost every investment judgment, valuation and decision. However, although it is important for investors to understand how to ‘beat’ cognitive biases, these are still almost impossible to completely eliminate, except through a system. Some general strategies include being self-aware, resisting the urge to trade, and seeking diverse perspectives. Some strategies for making the right stock investing moves in the future include slowing down, having a systematic approach to decision-making, and using artificial intelligence. Ultimately, Mehra is correct that understanding cognitive biases and following these steps to ‘beat’ them, is essential for improving overall investment strategy and achieving long-term investment success.