Cognitive biases and how they impact investment decisions

The human brain can sometimes think in ways that may not be entirely rational. These patterns are called cognitive biases. There are many different cognitive biases, but let’s take a closer look at two of the more common ones and how they can affect people’s investment decisions.

1) Loss aversion is a phenomenon in which people feel the pain of a loss much more than they would feel the joy of a gain. For investors, it can lead to poor decisions that can make losses more likely and more severe.

In early 2020, as the threat of COVID-19 became apparent, the S&P/TSX Index dropped more than 37% from its February peak, bottoming on March 23. Faced with the uncertainty of what lay ahead, the loss aversion mindset kicked in. Many investors sold their securities as the market reached its lowest level in almost a decade. Within three months, the market had recovered. By the end of 2021, the index had gained just over 18% from its February 2020 peak. Investors who held on would have received a significant positive return. Those who sold in March may have locked in significant losses in their portfolios.?

2) ?Anchoring refers to how decision making is influenced by a specific reference point or anchor. Once that anchor is established, it may alter future decision making from what it might have otherwise been. For example, if you see a pair of jeans for $300, you may think that’s too expensive. However, if you see another pair afterwards for $225 you might consider it a bargain because your mind has anchored the price of jeans at $300.?

In the investment world, Nortel provides an example of the impact of anchoring. Caught up in the Tech Bubble of the late 1990s, Nortel saw its price soar, peaking in the summer of 2000. A short time later the price dropped, and continued to drop until the company filed for bankruptcy. However, with each drop in share price, trading volume spiked. With each trade, the buyers may have anchored Nortel’s value at or near its peak and believed that buying it at the much lower price was a bargain.?

How to overcome cognitive biases

There are various ways you can protect yourself from the effects of cognitive biases. These include:

• Being aware they exist.
• Reflecting on the past to identify patterns in how you reacted to similar situations.
• Being curious and asking the right questions.
• Working with a financial advisor.

A financial advisor can act as an emotional buffer between you and your decisions. In periods of extreme market events, having an expert in your corner to help you analyze your investment decisions may prevent significant negative impacts to your financial plan.?