4 cognitive biases that can erode your portfolio returns

By James Yeo

The stock market can have ups and downs – it can either make you enough money to ride off into the sunset, or leave you so penniless that you lose your pants. Unfortunately, it is the latter scenario for many new investors, as they make many rookie mistakes such as buying high and selling low instead of the reverse.

You should recognise that some cognitive biases are crucial in order to avoid the common pitfalls of investing in stocks. A cognitive bias is also known as a flaw in judgment that happens due to errors of memory, social attribution, and miscalculations.

Without further ado, here are four cognitive biases that, if left unchecked, may prove to be detrimental to your portfolio returns:

1. Confirmation Bias

Confirmation bias is the tendency to search for information that only supports your views – and ignore information that contradicts them. For example: We usually prefer to hang out with people who hold the same beliefs or tastes as us, and stay far away from people with differing views.

However, confirmation bias is a no-no when it comes to investing. By actively seeking out information that only agrees with your investment thesis, it can easily cause you to underestimate risks and thus, make the wrong investments.

2. The gambler’s fallacy

Imagine yourself playing blackjack in a casino. The dealer shuffles the cards, and you place your bet. To your dismay, you lose one hand, then two, then three, and finally a fourth. You may think to yourself: “I’ve lost four in a row, so it’s about time I win the fifth.”

Statistically, how often you have won or lost does not affect future outcomes. The stock market functions the same way – just because a stock has been falling does not mean that it is guaranteed to turn around and increase in value.

Take, for example, Swiber Holdings Limited. The stock was at an all-time high of S$7+ in year 2007 before ending up at S$0.109 ten years later in 2017. For the benefit of those who are unaware, Swiber had declared bankruptcy because it was unable to pay off its huge debt load in the wake of the oil-price crash.

3. The ‘house money’ fallacy

Let’s take a look at the aforementioned casino scenario one more time. You walked in with $1,000 and have now won $10,000 – a 1,000% return!

Most people may think of the $9,000 winnings as “house money” and not your own. House money means that the money belongs to the casino (‘stock market’ in our case). With that, most gamblers would take more risks with the $9,000 earned, such as putting higher bets only to lose them all at the end.

Stock markets are similar environments; people who profit from investing may take more and more risks with the money they have earned. A sudden change in the stock market sentiment would wipe out all the gains and more.

Therefore, as a word of advice, people should treat every dollar they’ve earned as their own, because at the end of the day, their overall performance depends on how they handle their money over the long run.

4. Self-attribution bias

This bias describes people who have a tendency to think of accomplishments as a result of their own decisions, and blame negative outcomes to external forces beyond their control.

The truth is, there are plenty of scenarios where a successful investment was pure luck, and a loss was directly related to choices the investor made.

A classic example is the dot-com bubble which happened around year 2000. Many fund managers lost their shirts by investing in tech stocks that weren’t even making money at the time; meanwhile, legendary investor Warren Buffett managed to steer away from that and even picked up bargain stocks after the crisis unfolded.

To sum up, having this type of mindset is appalling. It may cause the investor to constantly make poor decisions in the future, as they would not actively recognise and learn from their mistakes of the past.

Conclusion

The above points are not exhaustive and are merely a small picture of the mistakes or bias at work during stocks investing. Nonetheless, it serves as a good starting point for us to be more aware of such common blunders and hopefully, cut short our learning curve to be successful in investing.