4 Ways Your Brain's Biases Are Costing You Money

If you’ve ever had the feeling that the stock market is rigged, perhaps it’s your own brain playing tricks on you. Humans have the most highly-evolved brain of any species on the planet, but sometimes our way of thinking can produce biases that we aren’t even aware of.

Credit Suisse analyst Michael Mauboussin recently looked at four psychological biases that consistently hurt investment returns.

1. Social Conformity

The idea of social conformity makes sense in certain contexts. It makes sense to emulate the behavior of others when they are more knowledgeable or skilled than you are.

There is also an inherent safety in doing what everyone else is doing. However, while it might make you feel good to buy the same popular stocks as everyone else, those types of stocks typically do not outperform the market.

When it comes to conformity in investing, Mauboussin quotes Benjamin Graham, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

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2. Pattern Seeking

Humans are predisposed to identify patterns, and this ability often makes our lives much easier. However, our ability to find patterns can sometimes cause us problems when there are no true patterns to be found.

The perception of patterns when no patterns actually exist is referred to by statisticians as a Type I error. In the stock market, the clearest example of this type of behavior is believing that past price performance is predictive of future price performance.

While there may be some value in technical analysis of stock charts, the idea that a stock is a good stock to buy now because it was a good stock to buy last year and the year before can be a costly (and incorrect) assumption.

3. Hyperbolic Discounting

This bias has to do with humans' ability to make rational decisions when it comes to delayed gratification. Research has shown that different regions of the brain are activated depending on whether the potential for a reward is immediate or in the distant future. The prospect of an immediate reward tends to cloud people’s rational judgement when it comes to money.

One example of irrational short-term decision-making is the choices made by U.S. military personnel during the military downsizing initiative in the early 1990s. When given the choice between a lump sum severance package or an annuity that was valued at about 80 percent higher, virtually all enlisted personnel chose the lump sum.

Another example: This bias may be why traders would prefer the potential for a 10 percent six-month gain rather than a 100 percent two-year gain.

4. Loss Aversion

The final bias that Mauboussin discussed is the idea of loss aversion, or how much people suffer when they lose money. A study by Kahneman and Tversky found that people tend to get about twice as negatively emotionally-affected by a financial loss than they are positively affected by a gain of an equal amount. In other words, in order to offset the unhappiness of losing $100, an investor would need to gain $200.

Research shows this bias is worse in women than in men, and it gets worse with age. It’s important for each investor to try to recognize and somehow mitigate this loss aversion bias. One way that investors can avoid the loss aversion bias when it comes to long-term stock investments is to check the market less frequently. The stock market has consistently generated long-term positive returns over time, so the longer you wait to check your account balance, the more likely you are to avoid seeing any red.

Takeaway

At the end of the day, there’s nothing that can be done to change the way our brain works. However, by learning about our brain’s natural biases, investors can learn to recognize when their market behavior is flawed and understand which approaches work best to eliminate the potential costly effects of these biases.