You Don't Know What You Don't Know (And What To Do About It)

February 8, 2016

 Last month we began a series on behavioral finance in an attempt to understand the ways in which we think and how our thoughts affect the ways in which we invest.  This week, we’ll dig further into the topic by discussing one of the two major types of behavioral biases: cognitive errors (the other type is emotional biases, but we’ll get to that later).  Cognitive errors are a result of cognitive dissonance which can be thought of as the discomfort you feel when something contradicts your beliefs (dissonance).  For example, let’s say that it is my personal belief that the Denver Broncos are the greatest team in all of football history, but one day I come across an article that points out that there are other teams that have won more super bowls than the Broncos.  This creates a dissonance in my thinking: I believe the Broncos are the best, but there is evidence that contradicts my beliefs.

 

Cognitive dissonance is important because it has significant implications for the way we make decisions.  Consider a few of the different types of biases that fall under the Cognitive Errors heading:

  • Conservatism: A bias in which people maintain their prior views or forecasts by inadequately incorporating new information.

For example, despite reading the contradictory article, I can continue to believe the Broncos are the greatest team in all of football history by failing to consider that the number of super bowl wins may represent an aspect of how successful a team is.

  • Confirmation: A bias in which people tend to look for and notice information that confirms what they believe, but ignore information that contradicts what they believe.

For example, I may only search for articles that make the Broncos look good and ignore anything that says they aren’t very good.

  • Illusion of Control: A bias in which people tend to believe they can control or influence outcomes when they can’t.

For example, I may believe that by living in Denver and wearing blue and orange on Sundays and sitting in my special chair and only eating Fritos during the game, that I can contribute to the Broncos winning (my dad yelling at the TV in the hopes that the refs can hear him is also an example of this bias).

  • Hindsight Bias: A bias in which people may see past events as having been predictable and reasonable to expect.

For example, after having watched the super bowl game on Sunday and knowing how it ended, I could say that I knew it would have played out that way all along – hindsight is 20-20.

 

For many, these biases are common – not just in finance, but in everyday life.  I would posit that the reason they’re so common is that it is very difficult for us as human beings to admit that we are wrong or that things aren’t as certain as we would like them to be.  Unfortunately, there is a great danger to ignoring the presence and impact of cognitive errors.  In investing as in life, when we fail to consider less comfortable alternatives we put ourselves at risk of not making fully informed decisions.  One of the worst things I can do for my clients is to fail to consider new information because I’m more comfortable clinging to my initial views on the economy or an investment because I don’t want to believe that things have changed or that I might have been wrong.  We see this play out when an individual is convinced of the success of a company.  Their investment becomes personal and their self-worth ends up tied to the outcome.  This causes them to behave irrationally.  They want to be right more than they want to be smart and so they seek out only information that confirms their belief and ignore anything that contradicts it.  If they’re right, they say “I knew it all along” and if they’re wrong, they blame someone or something else for their failure.  Instead of investing based on facts, they are investing based on feelings and that is a dangerous road to travel down.

 

One of the most beneficial aspects of our organizational structure is that we make investment decisions as a team and because we have sought to promote a culture of trust and safety within Cedarstone, I genuinely believe that we all feel like we can voice our opinions – even when they contradict each other.  The best weapon we have against making cognitive errors is to seek out information that contradicts our beliefs and make an unbiased effort to reconcile the two.  In my previous example, this means making friends with fans of different teams and considering their contrary opinions.  We don’t know what we don’t know, but we can help ourselves by considering all angles of a decision and not just the one that is comfortable and makes us feel good.  If you find yourself making emotional decisions about your investments, feel free to give us a call.  We’re always happy to chat.

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