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Are you an Investor who makes Cognitive Errors?

January 28, 2011 - 0 comments

One of the items on our “Rethink the Way You Invest” inventory involves behavioural finance and lists 8 cognitive errors often made by investors. 

  1. Overconfidence
    There is a difference between confidence, in which you have a realistic belief in your abilities, and overconfidence, in which there is an overly optimistic expectation that you will come out on top (often losing sight that there can be only one winner). Overconfidence in behavioural finance is a belief that you know the best securities to hold and the right time to buy or sell them. This behaviour leads to more frequent trading, higher turnover of a portfolio and lower returns. 
  2. Self Attribution
    Self attribution implies that investment success is due to your talent or foresight, whereas failures are due to outside influences. There’s a saying that you should not confuse brains with a bull market!
  3. Hindsight
    If you believe, after the fact, that an event was predictable, you have hindsight bias. So much has been written on the predictability of the 2008 market decline as we try to satisfy our need to find order in our world – we have to find explanations.
  4. Extrapolation
    Here we see the assumption that past trends will continue. There is a belief that past returns are related to future opportunity. How often have we assumed that the returns of the past year(s), whether good or bad, are sure to continue?
  5. Familiarity
    We tend to gravitate towards things that are familiar to us at the cost of exploring other opportunities. When investing, people often own a large number of shares in their employer corporation. On a broader market basis, there is a tendency to favour domestic rather than international holdings. This bias towards the familiar can result in a lack of objectivity as well as a lack of diversification.
  6. Mental Accounting
    We have a tendency to separate our money into pools, either by source or use, rather than as a whole. We have a separate account for our vacation savings and won’t recognize that paying off the high-interest credit card is more beneficial. If you hold your income investments in your RRSP and equities in a non-registered account, the returns on the two accounts will be different, but that doesn’t matter. It’s the overall return on your portfolio that counts.
  7. Regret Avoidance
    Not wanting to face the possibility of regret, we often end up being paralyzed, or we make hasty decisions. This can lead to holding on to losing stocks for too long in the hope that they will recover, or selling winning stocks because they may decline in value.
  8. Confirmation
    We look for research to support our opinions, often at the expense of seeing the whole picture. In the case of a favourite stock, we may look for analysts’ comments on increasing cash flow or higher dividend payments and not see a potential red flag caused by the loss of a large customer. Having a second opinion to explore both sides of the equation is a valuable tool to avoid confirmation bias.

Working with an investment professional can help to lessen the impact of these cognitive errors – which are essentially very human reactions to things life throws our way.

Member: Canadian Investor Protection Fund (CIPF) &  Member: Investment Industry Regulatory Organization of Canada (IIROC)
 

By: Kathleen Clough with 0 comments.
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