3 more cognitive biases you need to know

3 more cognitive biases you need to know

As outlined in a recent blog post, our minds are prone to numerous fallacies and biases. Just like you have a natural blind spot in each eye (where the nerve ending connects to the back of your cornea), we have natural blind spots in the way we think. To make better investment decisions, it’s critical to recognise and guard against them.

Previously we explained how Amy the anchor can lock you into a false reference point; how Eddy the endower can make you more forgiving of stocks you own; and how confirming Cathy can make you see only the arguments that support your cause. Here, I’d like to introduce three more cognitive biases that every investor needs to know: Harry, Fred and Gemma.

Harry Hindsight
Bio: Harry has 20:20 vision in the rear view mirror. He can connect all the dots to explain today’s outcome and how everything was present (and obvious) yesterday. He’s particularly good at forgetting all the contradictions and mixed information that may have been there before.
Weapons: Information is always clearer with all the facts in front of you. But see, the problem with predicting future earnings – is you never have all of tomorrow’s facts today. When you’re looking at conflicting data, you can come to a range of conclusions, only one of which may occur (it may be an unknown unknown that you hadn’t foreseen at all). Harry can inflate your confidence and lead to poor decisions down the track; he can also fill you with regret at not acting on (now) obvious insights.
Defence: One way to be accountable to Harry is to keep a record of your calls. Write a view, a reason and a date, and hold yourself to it – after all, your money will. It’s important to be aware that surprises do happen – you can’t predict an earthquake, but they will impact an insurer’s earnings. Your forecasts of the future are for a distribution of outcomes, not a certain one, and decisions need to be made with that in mind.

Familiar Fred
Bio: Fred isn’t very adventurous. He’s got a clear familiar comfort zone that he knows well, but he doesn’t really like looking outside of it.
Weapons: Fred’s lack of peripheral vision can lead to lost opportunities. Though he may know his universe well, he may block out options outside of it. He might be very comfortable with predicting mature business earnings, but underestimate growth and miss out.
Defence: There are a number of ways to avoid Fred. At Montgomery we are generalist analysts; this means we are used to looking at new industries, which is very helpful for avoiding familiarity bias. Alternatively, if you recognise that you don’t have expertise in a particular field, you can outsource that component rather than avoid it altogether. It’s fine to avoid a category of ideas, but only with sound reasoning behind it.

Gemma the Gambler
Bio: Gemma’s a believer in the next flip of the coin. She ignores the odds but knows the next one has got to be heads after 20 tails in a row.
Weapons: The Gambler’s fallacy can make you want to exit late or early. Gemma may whisper that after five up days you should take your winnings, or ten down days are too much, but she’s just a gambler and not using any concept of value in these suggestions.
Defence: Stick to fundamental bottom-up analysis and don’t get caught up in stock-price day-to-day noise. In the long term, value analysis provides returns, whereas responding to short-term stock-price gyrations is both costly and increases risks of losses.

As with Amy, Eddy and Cathy – these vision deficiencies are natural. Avoiding (or at least minimising) them is part awareness, part technique.