Emotions & Investing

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As humans, we are inherently biased. We constantly make judgements toward everything, be it people, job opportunities, government policies, and everyone’s favorite place to give their two cents, (drumroll please…) the market! And this is not a bad thing, it is simply who we are. It’d be naïve of anyone to overlook the reality that our decisions are a direct result of our a priori judgements. From a life-time of experiences and observations, we create somewhat of internal “filters” that we process our future decisions through, and these filters can paint our decisions with a shade of bias.

Before dabbling with individual examples, let’s take today to break down biases into two separate categories: Cognitive and Emotional.

Cognitive Bias

A cognitive bias is like a rule of thumb. In psychology, the simple, efficient rules we use as mental shortcuts are referred to as heuristics.  Think of your own rules of thumb, have they always led to proper decision-making? Odds are, not always.  This is because rules of thumb and heuristics are not always factual. Rather, they are what we have come to expect based on past experience.

Have you seen the commercial where a DJ, as in disk jockey, poses as a financial planner and gains people’s trust into becoming their advisor? It is a classic example of a cognitive bias.  Unknowingly, clients believe they are speaking with an actual financial planner, and accordingly, trust him with their wealth. Why? Because these people are courted in a lavish office by a man with a sharp haircut and a nice suit, using generic phrases like, “Let’s talk asset allocation.”

The point is that these people mistakenly assume that he is a certified financial planner because rule of thumb tells them, ‘nice office, sharp suit, those words sound meaningful…this guy must be legit!’ This is a classic example of cognitive bias. In investing, we can suffer from making the same types of assumptions based on the illusion of meaningful knowledge that in the past may have served us well.

Emotional Bias

There is definite overlap between cognitive and emotional bias. What differentiates them is that emotional bias is tied more to our feelings as opposed to our mental shortcuts.  Put simply, emotional biases distort our decision-making due to the influence of our feelings. Our positive or negative feelings towards something influences our fundamental belief of what’s true. Those beliefs, deeply anchored in our feelings, are hard, if not impossible to change, even when there is evidence to the contrary. Emotional bias helps to explain over-optimism or over-pessimism, where we are reluctant to accept hard facts that oppose our views, potentially causing mental suffering. Again, emotional bias is directly tied to our past experiences and our recollection of how those experiences made us feel.

Think of a person who was unfortunate enough to purchase a home in 2007. Most likely, they underwent a bit of mental suffering. That same person may hold disbelief about the sustainability of our current 8-year bull market due to his focus on the emotional recollection of the past, thinking, “I got swamped in 2007, why should now be any different?”  Although understandable, his view exemplifies emotional bias, as he is acting based on feelings as opposed to facts.

In investing, emotional biases can cause us to be reluctant to cut losses or take gains, because of our feeling of confidence in our own abilities to see what others cannot.

In later articles, I will dive further into specific examples of cognitive and emotional biases (believe me, there are many) and how they influence investor decision making. For today, the main takeaway is that there is no way to eliminate our biases, but by understanding them, we can mitigate their influence to promote logically consistent decisions.

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