A heuristic approach is usually a good thing. We tend to lean a lot more when our learning is hands on. But many times such an approach can lead us to a biased approach because we’re relying solely on one person’s experience (our own). It reminds me of a verse in the book of Proverbs that says there is wisdom in a multitude of counselors.
The same can be said about investing. When we rely only on one person’s experience and expertise, we can fall victim to either their or our mental shortcuts which can then lead to systematic mistakes. Then two problems emerge:
- We look at every situation through our rose colored glasses and force everything to fit our viewpoint.
- Even after we make a mistake, we may not be aware of it causing us to continue to systematically make it again and again.
We’re all biased to some degree. That’s inevitable. But biases can be reduced (though never fully eliminated) by getting a second or third opinion on which course to take … especially when it comes to investing our hard earned money.
Biases will cost you money. They can cause you to avoid risk in one situation (selling a winning investment too soon to “lock” in your gains) or expose you to too much risk (holding on to a losing investment hoping it will “come back”). There are times that selling your winners and holding on to your losers IS a good idea but it’s an even better idea to allow an unbiased third party such as a financial advisor to take a peek an your investing strategies so you don’t let your emotions bias your decisions.
Have you noticed any of these types of biases in your thinking or your investing habits?
23 common biases
- Recency bias: Drawing conclusions based only on recent information rather than a long term trend.
- Resolution bias: Failing to think beyond a preconceived notion (aka stubbornness!).
- Assumed association bias: Assuming certain associations exist with no real evidence.
- Authentication bias: A search (either conscious or unconscious) for supporting evidence that we made the right decision, while ignoring any and all evidence to the contrary.
- Mental accounting: The belief we are doing better than we are and making a decision because of it.
- Anchoring bias: Mentally locking information in our head even though it is now irrelevant.
- Sample size bias: Reaching a conclusion using only a small sample of the available information (the smaller the sample size, the greater the influence of luck on the results we get).
- Allegorical bias: Making a decision based on one person’s advice or one person’s experiences.
- Data mining bias: Finding patterns in randomness and using them to predict the future.
- Bubble bias: Failure to recognize that above average or below average results won’t necessarily continue into infinity.
- Connection bias: Badly estimating the likelihood that certain foundational events will happen when those particular events must take place for a particular outcome to occur.
- Overconfidence bias: Failing to recognize that neither we nor our financial advisor is Warren Buffet … and never will be.
- Optimism bias: Ignoring what is staring us in the face while believing that “thinking positive” will make everything okay.
- Incorrect anchor adjustment: Assuming an outcome of an event will be exactly the same as the outcome of a similar prior event without examining the differences.
- Fear bias: Running from a down market.
- Greed bias: Running toward a bull market.
- Hindsight bias: Evaluating a decision after an event has taken place but now with perfect knowledge of the outcome (aka predicting the past).
- Avoiding uncertainty: A preference for stability rather than uncertainty, for security rather than risk.
- Status Quo: An aversion to change even when the change is for the better.
- Regret avoidance bias: Feeling more regret toward committed actions that have turned out badly rather than omissions that could have turned out favorably.
- Consistency bias: The need to be consistent with our decisions regardless of the cost.
- Escalation of commitment: The tendency over a period of time to increase the support of our initial decision.
- Crowd bias: The tendency to view the actions of others as validating a decision.
While it’s easy to see these biases at work in others, recognizing your own biases is much more difficult … and important. I’m sure if you think about some of the bad decisions you’ve made in the past, you’re likely to discover one of the biases affected your judgment in some way. I know I can.
By understanding that these biases exist in your own decision making process will ultimately help you control and overcome them. Print out this list and keep it somewhere so that when you slow down and think about your next decision, you’ll know what to look out for.