Cognitive biases can hurt your investment returns—but they don’t have to

• Cognitive biases act like optical illusions for our perceptions, changing how we interpret information.
• These biases were evolutionarily helpful for our pre-modern ancestors, but can lead to self-sabotaging behavior when it comes to money.
• Being aware of your own biases is the first step toward correcting them to make better investing decisions.

Becoming an engaged investor takes some effort. You have to educate yourself about how various types of investments work, develop the discipline to set aside money now to ensure a prosperous future, and adjust as needed as your life circumstances change. 

And then there’s the challenge we don’t talk about as much: overcoming the cognitive biases that threaten to derail even those with the best intentions. That’s what we’ll cover in this piece. 

Before diving in, here’s what you need to know: because of the way our brains are wired, we all have cognitive biases. Those biases can and do affect the choices we make about investing. But according to the psychology professionals we spoke to for this piece, by becoming aware of what these biases are and how they work, we can overcome them to ensure that we’re making sound, rational decisions with our money.

What are cognitive biases and why do we have them?

First, let’s make sure we’re all on the same page about what a cognitive bias is.

Bo Bennet, who has a PhD in social psychology, explains it like this: “A cognitive bias is like an optical illusion that distorts our reality but affects how we think rather than what we see.”

So if an optical illusion happens when we improperly interpret visual stimuli, cognitive biases cause us to improperly interpret other types of stimuli. Why did our brains evolve this way? Because, for most of human evolution, these biases actually helped us stay alive.

Think about this scenario: you’re walking outside and you see something snake-like at your feet. Without thinking, you jump out of its way and run until you’re well out of slithering distance. This bias toward action is super helpful in the context of a snake-or-stick: if it’s a deadly snake and you run away, you survive. If it’s just a stick, you survive. Win-win.

The reason these biases cause problems, according to Derek Hagen, a CERTIFIED FINANCIAL PLANNER™ professional, Certified Financial Behavior Specialist, and Financial Behavior Coach with Money Health Solutions, is that “money is something our ancestors didn’t have to worry about. Money works differently [from the stick and the snake] and goes against our natural instincts.”

Once you hear it, it makes perfect sense: we have cognitive biases because they helped us survive in a different world, when our survival depended on responding to our physical environment rather than the web of intangible forces that now determine our wellbeing.

Unfortunately, the world of investing doesn’t follow the same rules as the jungle or the savannah. As a result, the biases hardwired into our brains by hundreds of thousands of years of evolution can actually hurt our ability to invest money well.

How to overcome psychological biases

Given that our cognitive biases can push us to make bad investing decisions, it’s important to develop some strategies for overcoming those biases.

So how can we do that?

“First and foremost, we have to admit that we have biases,” says Elisa Robyn, who has a PhD in educational psychology and currently works to counsel people about their relationship with  money. Once we’ve acknowledged that our biases exist, Dr. Robyn recommends learning more about how these biases affect our decision making.

“There are some wonderful books on the topic that point out the ways our brains easily mislead us, especially when it comes to money,” she said. “Much of the field of Behavioral Economics is based on the psychology of the brain. I encourage people to read at least one book and accept the fact that we are all affected by these biases.”

Dr. Bennet agrees. “To overcome biases in general, awareness of the biases is the greatest step you can take,” he says. “Being aware of biases is like pulling back the curtain of our minds and seeing how the mind really works. Once we have this awareness, we can consider how the bias might be affecting our decision, take that interference into consideration, and make better decisions.” 

Sure, that sounds like a lot of work. And at first, it is. 

“But it eventually becomes a subconscious process,” says Dr. Bennet, “at which time it will take no more effort to make better decisions.”

Practice, in other words, makes perfect. (If you’re interested in mastering the process of overcoming your cognitive biases, take a look at the course Dr. Bennet teaches on the subject).

Another effective habit, according to Hagen, is to pretend your current financial situation is happening to a friend. 

“We tend to spot biases in others more so than ourselves,” says Hagen. “So a good strategy when making financial decisions is to ask yourself what advice would you give to someone else who is facing a similar decision.”

Dr. Robyn suggests listening to someone whose opinions differ from your own. “Working with people who disagree with our strategy, though not aggressively, can help us clarify our decisions,” she says.

To get better at making investment decisions, follow these five steps:

1. Accept that you have cognitive biases.
2. Read up on these biases.
3. Practice making decisions by consciously considering how your bias is affecting you.
4. Pretend someone else is in your situation and see what advice you’d give them.
5. Consider the ideas of someone who disagrees with you.

7 cognitive biases to watch out for

So what exactly should you be looking out for as you make decisions about money and investing? The experts we spoke to highlighted the following cognitive biases to be on the lookout for:

• Confirmation bias: This bias makes us interpret (and even seek out) information so that it confirms our existing beliefs. According to Hagen, “confirmation bias helps us avoid emotional discomfort from thinking we might be wrong.” Dr. Robyn cautions that it can lead to us being overly influenced by people who agree with us. In investing, confirmation bias means we might avoid processing information that suggests we’ve made mistakes or that we should change strategies. That’s dangerous because it can cause us to double down on ineffective strategies rather than adapt as we learn new information.

• Reactive devaluation bias: Dr. Bennet explains that reactive devaluation bias happens “when proposals are rejected or ignored because of the animosity felt toward the person or source making the proposal.” In other words, when we discount an idea because we don’t like the person who presents it. This can prevent us from taking good advice that comes from someone we don’t like.

• Loss aversion: This bias makes us feel like there’s more to be lost by giving something up than there is to be gained by acquiring something. It can push us to hold on to stocks and other investment vehicles for longer than we should because, essentially, we feel attached to them. In the past, explains Hagen, “avoiding pain and risk was far more important than gaining pleasure.” That’s great when your challenge is avoiding a snake, but not so great if you’re deciding whether to use tools like margin loans to increase your returns. “I have had clients tell me that they have too much invested to pull out, and will continue to lose money in an effort to not lose money,” says Dr. Robyn.

• The “Lake Wobegon” effect: In the town of Lake Wobegon, of A Prairie Home Companion lore, all the children are famously “above average.” While the description was used to humorous effect on the long-running public radio show, this cognitive bias is real and can hurt our ability to invest well, warns Dr. Robyn. “Each of us believes we are more astute than average,” she says. “This can cause investors to resist changing their financial strategy.”

• Optimism bias: Our optimism bias makes us believe that positive outcomes are more likely than they actually are. “We need to work around our brain’s tendency to overestimate our intelligence [and] underestimate our losses,” warns Dr. Robyn. If we don’t, we may make overconfident investment decisions. The optimism bias is one reason inexperienced investors continue to be intrigued by penny stocks – while the theoretical potential for upside is great, the reality is that penny stocks with outsized returns remain just that – theoretical.

• Fear of missing out (FOMO): According to Hagen, “fear of missing out exists because we have a natural tendency to fit in with our tribe, and if we were kicked out of the tribe, it was bad for us.” But FOMO in investing can lead us to hop on the bandwagon of whatever investment is currently “trendy” rather than doing the work of researching which investments and investment strategies make the most sense for our individual goals and circumstances. Worst, FOMO almost always strikes around individual stocks or assets–consider the exuberance by many investors to buy shares in new tech IPOs. For many long-term investors, especially when just starting out, index-based investment vehicles can be  more effective in achieving their goals than trying to pick individual stocks.

• Gambler’s fallacy: Angelika Y. Sadar, M.A., is a licensed psychologist and a cofounder of Brain Arc America. She explains the gambler’s fallacy like this: “Gamblers rely on the fact that they expect the past to influence the future. For example: ‘My luck is going to change,’ or ‘I can’t keep losing,’ etc.” Obviously, this isn’t true; past events have no influence on future events. It’s also not rational. But as Sadar explains, “As a general rule, decisions about money are apt to be made based on biases” rather than reasoned logic. “By definition,” she adds, “biases are illogical / irrational and are generally incompatible with sound decision making.”

This list isn’t exhaustive. The important takeaway here is to acknowledge that you have cognitive biases – we all do. They’re part of why we survived this long as a species: they helped us deal with some part of our evolutionary past.

The other important takeaway is to remember that making a few bad decisions along your investing journey doesn’t mean you’re bad at investing. As Warren Buffett once said, after speaking about his biggest investing mistakes,

“You only have to do a very few things right in your life so long as you don’t do too many things wrong.”

Warren Buffett

As Dr. Robyn explains: “There is a mistaken belief that if we are smart, we only make good investments.” In reality, that’s not true. Smart people make bad investments all the time. 

More important, though, is that making good investments is less a matter of how smart you are and more a matter of how you engage with information available to you. If you consistently seek out new information to inform your investment habits and work to be aware of and overcome the cognitive biases that might affect how you interpret that information, you will have much better odds of achieving your investment goals, whatever they happen to be.

Cognitive Biases & Investing: A Reading List

Ready to get a better understanding of how your brain works and how it affects the way you invest? These books offer an excellent starting point:

• The Psychology of Trading: Tools and Techniques for Minding the Markets, by Brett Steenbarger
• How We Know What Isn’t So: The Fallibility of Human Reason in Everyday Life, by Thomas Gilovich
• Thinking, Fast and Slow, by Daniel Kahneman
• Irrational Exuberance, by Robert J. Shiller

Contributors

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M1 Holdings, Inc. and its affiliates (together, “M1”) relies on information from various sources believed to be reliable, including clients and third parties, but cannot guarantee the accuracy and completeness of that information. M1 does not provide investment, legal, or tax advice and you are encouraged to consult with your personal investment, legal, and tax advisors. 

Bo Bennet, PhD, Derek Hagen, Elisa Robyn, PhD, and Angelika Y. Sadar are not employees of M1 Holdings, Inc. or any of its affiliates.