Whether you make an investment or not should always be considered carefully. It becomes difficult, however, when one’s own decision is influenced by errors in perception. The following post explains what cognitive biases are and how traders can overcome them.
• Cognitive distortions are mistakes in thinking and perception that influence decisions
• Investors need to be aware of their misperceptions
• The correct handling of information is essential in order to avoid misperceptions
What are cognitive biases
Cognitive distortions describe systematically occurring errors in thinking and perception that influence human decisions, as IONOS explains. Every time you perceive, think, judge, or remember something, you are being influenced by presuppositions in the brain. In addition, memories in particular are particularly susceptible to cognitive distortions, since storage and retrieval of them are always dynamic. This means that each retrieval changes the “entry” in memory. Cognitive distortions accumulate above all when one has to make decisions quickly, when the amount of information available is too large or when too little meaning can be deduced. The consequence of this is that uncomfortable or inappropriate information is often hidden, so that appropriate and convenient information leads to the well-known “gut decisions”, explains Insider Week.
How cognitive bias affects human decisions
Investors are more likely to be “hit” by some types of cognitive distortions listed in behavioral psychology than by others.
Confirmation Bias: This is a widespread distortion of one’s view of reality. Because people are always looking for confirmation – especially when they are bombarded with a large and sometimes contradictory wealth of information. In such cases, people are often inclined to pick out the information that confirms their own hypotheses, opinions and prejudices that already exist. In extreme cases, this leads to a selective perception of precisely the information that confirms and solidifies one’s own preconceived notion.
Texas Sharpshooter Effect: Imagine a marksman shooting wildly at a barn door and then looking at the bullet holes. He draws the circles of a target around the bullet holes that are very close together and finally saws them out. Proof of a marksman. The same applies to the Texas Sharpshooter effect. Results are interpreted afterwards or even manipulated in order to adapt them to an expected scheme. Results that do not fit the schema are simply hidden or deleted. However, if this is not possible, they are explained and put into perspective using fantasized arguments. Sometimes this effect can be followed in successful traders on the net who generate exorbitantly high profits in a very short time. “These people show you the cut-out pane, they hide the barn door,” Insider Week said.
Loss aversion and sunk-cost fallacy: These two types of Cognitive Bias are very close and often seen in trading. Something people always want to avoid is loss. Losses are therefore often rated higher than comparable gains. When a trader is invested in a losing position, the thought of the capital already invested and the time expended often discourages them from closing the position and moving on. In everyday life, the “sunk-cost fallacy” can also be observed when companies stick to the development of a product despite the hopelessness, based on the investments already made.
Wishful Thinking: Wishful thinking is also a distortion of reality. Wishful thinking goes hand in hand with loss aversion and the sunk-cost fallacy. People often tend to be guided by pleasant notions rather than base their decisions on facts and rationality. This often creates a mentality of “it’ll be alright” or “everything will be alright” instead of focusing on the actual circumstances.
According to Insider Week and Banxbroker, other cognitive biases that affect traders more often include Optimism Bias, Endowment Effect, Bandwagon Effect, Hindsight Bias and the Dunning Kruger Effect.
How to overcome cognitive biases
But as an investor, how can you protect yourself from falling victim to cognitive distortions? The blog Finlog dedicated an article to exactly this question. In order to recognize one’s perception errors in the first place, it is helpful, for example, to carry out a written reflection or an evaluation of past trades or investments. This should be broken down into clear criteria. It should also be assessed which feelings and influences the trader may have been exposed to when making this decision. Also, it is wise to capture both the emotion and the trading strategy while entering and exiting trades at the precise moment this process is taking place. Only in this way are the notes honest and unadulterated.
It is also helpful to keep a checklist. At best, this should include factors to consider when making an investment and how to proceed with an investment in certain situations. Here you first define certain criteria that must be met before an investment is even made. Example questions that could be noted in the list are, for example: “How did I come across this investment idea? What emotions do I have when I think about this investment idea? If my idea goes wrong, what exactly do I do with my investment? What do I do me at 10/20/100 percent profit? How do I feel after the trade is closed?”
After all, the correct handling of information is also of great importance. It starts with the order in which the information is recorded, which is why the order of the individual points on the checklist should be carefully considered. This is so important because people subconsciously sort incoming information in order of importance based on the order in which they take it in. Added to this is the enormous amount of information that affects investors on the stock exchange. It is therefore important to learn which information is important for your own investment and which is not. Of course, it also takes a certain amount of time and experience to recognize this. “Ultimately, experience is the best teacher. At some point, this experience also gives rise to a certain intuition that you should trust,” says the blog post.
Editorial office finanzen.net