Cognitive Biases and Emotions
Cognitive bias refers to the reliance on limited information or pre-conceived notions when making decisions, while emotions are a person’s “state of mind” during the decision-making process. The societal impact of cognitive biases has been written about extensively in the media over these past few years, but how biases impact investment decision-making has not been covered as extensively, and until recently the fields of behavioral economics and behavioral finance were under-developed and it was not until 2017 that a behavioral economist, Richard Thaler, was awarded the Nobel Prize in Economics. (Daniel Kahneman, author of Thinking Fast and Slow, was a psychologist who previously won the Nobel Prize in Economics in 2002 based on the research he did with his partner Amos Tversky in the 1970s-80s)
Cognitive Biases and Emotions
The fields of behavioral economics and finance are concerned with the effect of psychology in appreciating why people behave like they do in the real world, in the case of behavioral economics, and how investors behave in the marketplace, in the case of behavioral finance. Both fields differ from the classical approach, which largely assumed people have well defined preferences, and make informed and rational decisions.
Cognitive biases and emotions have the potential to impact our financial lives – positively or negatively. To mitigate against negative influence on decision-making from cognitive biases and emotions it is critical to be aware that both exist, and to have a process that reduces the influence of both.
There are several cognitive biases that could impact investment decision-making.
Confirmation Bias: Refers to the behavior where people seek information that confirms a pre-existing belief and ignore more objective information.
Anchoring: Refers to the practice of jumping to a conclusion based on the first piece of information a person receives or possibly holding onto a belief and jumping to a conclusion.
Overconfidence: Occurs when a person has too much faith in their own analysis or ability, possibly leading to higher risk asset purchases or concentrated positions.
Choice Paralysis: Occurs when a person has too many choices leading to decision paralysis from too much information.
Loss Aversion: Refers to the tendency for people to sell those assets that have a gain, while retaining assets that have a loss. Research has shown that people simply feel the pain of a loss more than the joy of a gain.
Representativeness: Occurs when we think recent events will continue.
Herding: Refers to simply following the crowd.
There are also several emotions that come into play that impacts a person’s state of mind when making decisions.
Happiness
Pride
Concern
Jealousy
Resentment
Insecurity
Fear
Anger
Sadness
Biases and emotions could have major consequences on how we make investment decisions, and the impact could be felt in how we spend money, our choice of investments, and even how much debt we are comfortable with assuming. It’s by understanding the potential impact they have on decision-making that puts us in a better position to mitigate negative consequences.
Mitigating Biases and Emotions
Several steps can be used to mitigate the impact of biases and emotions, but perhaps the most critical step is to simply be aware that they exist.
Self-Awareness: Know yourself and your frame of mind when making critical decisions.
Bias Awareness: Biases exist, but by being aware of them we can become better critical thinkers and decision-makers. By being aware we can mitigate against our own blind spots.
Objective: Refers to knowing what you are trying to accomplish, and this objective guides many downstream decision-making. For example, if the objective of your investment account is saving to buy a house the investment selection is very different then if your objective is saving for an infant’s college education.
Different Information Sources: Look for information from a wide range of sources to get multiple perspectives.
Devil’s Advocate: Seek out others who have different opinions in order to challenge perceptions and conclusions.
Firm-Level Impacts
Investors also need to be aware of how cognitive biases and emotions impact management decision-making since these decision-making impacts company performance. In a white paper by Kathleen Locklear, she noted how cognitive biases have a distorting effect that could preclude management from recognizing early earning signs of emerging risk. These emerging risks represent risk that once it manifests itself could prevent a firm from meeting its business objectives but also possible failure.
To show what’s at stake, 86% of the companies on the original Fortune 500 list in 1955 no longer exist. At one time many of these companies were high performers and among the most well-respected companies, yet they did not deploy effective strategy to either mitigate or take advantage of disruptors to their business models.
To be successful, firms must deploy mechanisms that mitigate cognitive biases. A positive corporate culture can mitigate cognitive biases and is one of the best ways for a firm to build and sustain competitive advantage. Culture drives conduct, conduct drives behaviors, behaviors drive decision-making and outcomes, and its outcomes that determine success or failure.
Investors need to be aware of how biases and emotions can influence management’s decision-making because bad decisions by individuals within firms can ripple throughout firms – the same as good ones. Investors need to assess how well firms deploy mechanisms that also mitigate bias. This type of qualitative analysis is challenging but investors can start by looking at the make-up of boards and senior management to see if either or both are dominated by insiders or if a firm is attracting new talent, and disclosures can be reviewed to get a sense of firm commitment to diversity and inclusion, and what it’s corporate value are.
Investors can also use corporate governance scores that are calculated by third-parties, one of which is Institutional Shareholder Services (ISS). ISS calculates a Corporate Governance Quotient from eight factors (https://www.issgovernance.com/esg/ratings/governance-qualityscore/ ):
Board structure and composition
Audit or accounting issues
Charter and by-law provisions
Laws where the firm is incorporated
Compensation practices
Qualitative assessment
Insider ownership
Board education
Research has shown there is a positive correlation between good corporate governance and shareholder returns. A successful team is comprised of a talent pool whose skills and backgrounds balance each other out, and firms that attract, retain, develop and empower talented people are in the best position to enhance culture, sustain competitive advantage, and give investors above-average returns.