Cognitive bias in investment

In investing, the ‘human’ element should be able to add value. After all, humans should make rational decisions, based on the information they have available. However, it turns out that humans are prey to all kinds of unconscious bias which, left unchecked, can make them very poor investors.

These cognitive biases are mental short-cuts that can serve us well in everyday life but are unhelpful when it comes to investment. There is no way of eliminating them definitively, but recognising biases can mitigate their effect on performance and returns. It is important for an investor, retail or professional to understand and manage them in order to avoid an adverse impact on their portfolio.

The most obvious cognitive biases are visible in the way investors use information. For example, there is a tendency to assume that information is helpful, therefore more information is more helpful. In fact, the way investors use information can lead to poor decision-making. They may pick the wrong information, interpret it poorly, oversimplify it or attribute too much importance to it.

Information can make investors over-confident, believing that because they have lots of information, they must be well prepared to make best decisions. However, too much information can obscure rather than inform. Investors are inundated with information – GDP figures, manufacturing data, analysis from financial commentators. Much of it is useless and a distraction from what’s relevant.

The most obvious example is when investors decide to buy or sell investments on the basis of short-term movements in the price of a share. They may have bought shares in the company for the long term, but are suddenly unnerved by volatility in the price. In general, this results in investors selling up when markets are low and buying when markets are high – a reliable way to lose money over the long term.

A good investor should consider the possible consequences if they are wrong and test the strength of their investment thesis, considering arguments both for and against to build a considered view of the merits of an investment.

Selectivity

Meanwhile, investors may be excessively selective in the information they use, a phenomenon known as confirmation bias. They cherry-pick the information that supports their own views, rather than challenging their existing opinions or judgements. This can result in failure to appreciate investment risks properly because they are unaware of contrary points of view.

A good investor should consider the possible consequences if they are wrong and test the strength of their investment thesis, considering arguments both for and against to build a considered view of the merits of an investment.

Investors also tend to give too much weight to what has happened in the past. Many portfolios today are built on the assumption that the future will look like the past, that bonds and equities will move in opposite directions, or that government bonds will protect investors’ capital during a downturn.

To assume this, while ignoring phenomena such as the impact on markets of quantitative easing and rock-bottom interest rates over the past decade, can result in investors possessing a portfolio that has been constructed to weather or thrive in market conductions that do not in fact exist.

Hindsight bias

What is known as hindsight bias can also lead to investors misinterpreting their past performance. Fund managers in particular are often guilty of taking credit for their successes and blaming their failures on unpredictable market events.

However, it is critical to successful investment to reflect on mistakes and examine why they occurred, and how they can be avoided in the future. Unless the investor takes hindsight bias into consideration, it can cloud their objectivity in assessing past decisions, and inhibit their ability to learn from mistakes. Markets do not remain static, and investors need to be capable of adapting to them as they change.

Similar to hindsight bias is anchoring, under which investors rely too heavily on a particular piece of past information. For example, they may assume that because Unilever shares have always performed well, this will continue indefinitely. This could be a false assumption – the fortunes of individual companies can always ebb and flow, and past information should never obscure present reality.

The perils of forecasting

The investment world loves to make forecasts – it is way of demonstrating superior skill and knowledge. But few people review forecasts afterwards and hold them to account. That’s good for forecasters, because scientific study has shown repeatedly that people are bad at forecasting.

For example, Bloomberg has found that the Bank of England, and its teams of highly-qualified economists, generally has a poor record in trying to predict the inflation rate accurately.

While it is tempting to suggest that there’s something wrong with the Bank of England’s assumptions, or the reasoning of its economists, the problem is more likely that inflation is an extremely complex issue and its future level is very difficult, if not impossible, to predict – yet that does not stop investors and economists from trying.

The investment community places great emphasis on predictions, often using them as the basis for an investment strategy, since the job of managers is to use their judgement to position a portfolio for the world as they see it.

The need for flexibility

The danger is that it becomes more difficult to recognise changes or mistakes and adjust accordingly. Investors need to recognise that a forecast, even in areas less hard to assess than inflation, is not set in stone, so they need to leave flexibility and humility to respond to developments as they arise, even if they cast doubt on the validity of the original scenario.

Embedded in this is the problem of over-confidence: people tend to maintain the conviction that they are right and are slow to acknowledge mistakes, which can lead to poor analysis and decision-making.

There’s also the problem of groupthink, which arises in many areas of life and has been identified as a major contributor to the global financial crisis as decade ago. Too many similar executives in similar companies are prone to think in a similar way, and to exclude views and ideas that don’t fit the template.

In business, groupthink leads to inadequate risk management – and is part of the reason that investment managers are now increasingly looking at the benefits that companies with diverse executive ranks, boards of directors and workforces may enjoy.

Running with the crowd

Investors generally take comfort in running with the crowd. This false reassurance is the reason behind almost every speculative bubble in history, from tulips to dot-coms, and by definition, this is unlikely to make someone a successful investor.

It is likely to see them buy when everyone is crowding in and prices are at their highest, and to sell out when other market participants are at their most pessimistic. The exhortation of Baron Rothschild, an 18th-century member of the banking family, to “buy when there is blood on the streets, even if the blood is your own”, remains good investment advice.

To stand apart from the crowd, an investor needs to be sure of the rigour of their own analysis, whether about the economy in general, the market or individual companies, otherwise they simply risk succumbing to over-confidence.

No investor can completely suppress cognitive bias, but the crucial response is to be aware of it and to incorporate steps within the investment process to mitigate its effect.