Mind games: 4 cognitive biases killing your investing returns

As if there wasn’t enough to wrap your head around as a stock investor, there’s another constant adversary we have to contend with - ourselves.

It’s not enough to simply do your research and execute on a plan, you need to overcome some of the very things that make you human.

The stock market may be more data-driven and sophisticated than ever, but it’s still fundamentally about people.

And people can make emotional and illogical decisions despite their best efforts and intentions.

Here are 4 common cognitive biases you need to be aware of as an investor and how you can overcome them.

1. Sunk cost fallacy

Nothing can potentially harm your investing returns like the sunk cost fallacy.

In investing terms, you’d be committing the sunk cost fallacy any time you held on to (or continued to buy) a stock based on the fact that you already own it and not based on a logical assessment of its current prospects.

The sunk cost could be capital you’ve invested, but it could also be the time and effort you put into researching or following a certain stock.

The sunk cost fallacy clouds our judgement and makes us prone to making poor decisions, whether that’s the opportunity cost of not investing elsewhere, or losing more money as the investment continues to decline.

It may even see you throw good money after bad in a misguided way to bring down your cost basis or make the most of any potential price recovery.

The best way to avoid the sunk cost fallacy is to reevaluate your current position with fresh eyes.

Say you had thrown $10,000 into IDP Education (ASX: IEL) at the start of the year.

It’s now down around 71% YTD, including a precipitous 50% drop at the start of June off the back of huge earnings adjustments.

That would leave your initial $10,000 investment at around $2,900 at current prices.

Sunk cost fallacy would tell you to hold onto IDP in case the share price bounces back, or even double down while prices are “cheap”.

While that could prove to be the right move, the point is that you should be making each subsequent decision based on the current information, not what has happened in the past or your existing relationship with the stock.

Investing is forward-looking, and dwelling on the past can get in the way of doing that. 

As Charles Schwab's guide suggests, "the fear of acknowledging a 'loss' can keep us looking backward at events we can't change, when our interest lies in thinking about what comes next."

In our IDP example, say you had that remaining $2,900 in cash ready to invest, would you be investing it in IDP right now, or would you be avoiding it with a ten-foot pole?

How to overcome sunk cost fallacy: Regularly review your portfolio and strategy, make investing decisions objectively, seek an external perspective.

2. Confirmation bias

Confirmation bias is the tendency to only consider information that supports your pre-existing beliefs and subsequently fail to take on board new information or developments that may challenge your thesis.

Say you’ve done your due diligence on a stock and believe its fundamentals suggest it might be undervalued. Let’s take Google (NASDAQ: GOOGL) as an example.

You invest some money and follow the company closely, finding positive developments and data to support your investing decision, like its attractive P/E ratio and revenue growth.

But you manage to look past the potential threat from generative search models or overlook Google’s ongoing legal issues as they don’t support your bullish sentiment.

That’s confirmation bias. It can mean you’re investing with blinders on, which is a dangerous proposition.

Confirmation bias can be especially hard to overcome as it’s not always obvious when it’s happening.

One way to avoid it is by deliberately making a counter-argument against your current investing thesis. 

This is a strategy adopted by Magellan: "Our approach involves a constant ‘inversion’ of the investment argument to understand potential flaws in our reasoning. We make it a point to reassess our investment rationale, particularly in light of emerging data, and to rigorously test our presuppositions."

How to overcome confirmation bias: Build the contrarian case for your investments, seek opposing views.

3. Hindsight bias

Hindsight bias is a psychological perception that a past event was actually easier to predict than it actually was at the time.

This could be incorrectly remembering that you accurately predicted a past event when you didn’t in reality, or simply overemphasising your conviction over a decision that you didn’t act on at the time.

It’s a sensation that’s probably familiar to most investors.

If you’ve ever looked back at say the NVIDIA (NASDAQ: NVDA) stock chart and asked yourself the question “why didn’t I invest back then, it was so obviously going to skyrocket?”, then you’ve suffered from hindsight bias.

But the danger of the bias isn’t simply the frustration of missing past opportunities but how it may influence your future decisions. Like confirmation bias, it colours our view of the facts.

It may lead to you overestimating your actual ability to accurately predict the future or force you to make rash judgements in order to not repeat your perceived inactions of the past.

In our Nvidia example, it might be rushing into making an investment on a similarly-speculative stock to make sure you don’t miss out on the “next NVIDIA” despite the investment having a completely different risk profile.

How to avoid hindsight bias: Keep a journal or record of your thoughts so that they aren’t misremembered or distorted in future, make a mental note of all the times your predictions were wrong.

4. Loss aversion

Loss aversion was a cognitive bias identified by influential psychologists Daniel Kahneman and Amos Tversky in the 1970s.

It often goes hand-in-hand with the endowment effect, where individuals place more value on something they already own than an identical item that they don’t.

The central argument behind loss aversion is that the pain of a loss is more severe than the joy we feel from an equivalent gain.

Simply put, losing $5,000 on a stock feels worse than gaining $5,000 on a stock feels good.

This can manifest itself by making you less willing to take risks for fear of losing money, or dwelling on losses instead of pursuing opportunities to make gains elsewhere.

Alternatively, it can also reduce the satisfaction you get from making successful investments, pushing you to make riskier decisions in order to chase the diminished pleasure you receive when making money.

How to avoid loss aversion: Set clear investment goals, use a strict asset allocation framework.