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How to Avoid Cognitive Investing Biases on the Road to Financial Independence

July 3, 2015

Cognitive Investment Biases

In celebration of Independence Day, your Money Guys are talking about how our emotions can interfere with achieving financial independence.

We all know that being invested in the stock market puts our money at risk, which can cause a roller coaster of emotions at times. When the market is up, we’re happy, and when it’s down, we’re depressed and anxious.

Letting your emotions influence your financial decisions, especially when it comes to your investments, is a bad idea. How can we push our emotions aside so they don’t cause us to make grave mistakes with our portfolio?

Brian and Bo give you the answers in this episode, and discuss 15 cognitive investing biases to avoid on the road to financial independence.

Don’t Let Your Brain Hold You Back When it Comes to Money

Rick Edelman’s book, “The Truth About Money,” reviews the cognitive biases investors are most at risk for, and Brian goes through each in detail. He provides insightful examples so you can recognize when your emotions might be controlling your investment decisions.

The first step in being able to avoid these biases is to simply be aware of them. All too often, we get caught up in our thoughts and rationality goes out the window. You don’t want to play around with your emotions or your money, especially when it comes to growing your wealth to reach financial independence.

Here are 15 cognitive biases to stay away from as an investor.

 

  • Intuition Bias: Do you rely on your gut to make investment decisions? It goes without saying that’s a big mistake!
  • Mental Accounting Bias: This is when we treat our money differently depending on where we’ve mentally allocated it.
  • Compartmentalizing Bias: If you have multiple investment accounts, are you factoring in the investments you’re holding in all of them when figuring out what to invest in? Or are you viewing each as a separate account? You shouldn’t compartmentalize your investments.
  • Pattern Recognition Bias: Many of us are guilty of seeking out patterns that don’t exist. This is why “past performance does not guarantee future results” exists.
  • Recency Bias: We have a tendency to focus on current events, and this might cause us to base future predictions on how the present is going.
  • Proud Papa Bias: This occurs when we fall in love with our investments, or when we have a personal interest in seeing a stock do well.
  • Optimism Bias: This is when we think bad things only happen to others – not us – which causes us to be overconfident in our investments and to underestimate risks.
  • Illusion of Control Bias: If you think your actions control events, you’re guilty of this one. Just because you purchase a stock doesn’t mean it will perform well.
  • Pessimism Bias: The opposite of optimism bias, this is when we second-guess all of our investment decisions and can’t take action.
  • Catastrophe Bias: A combination of the recency and pessimism biases, this occurs when we think another recession is just around the corner, and hold ourselves back from entering the market because of that belief.
  • Regret Aversion Bias: Have you ever made such a bad mistake, you take every measure you can to avoid making it again? This limits your opportunity, especially with your money.
  • Endowment Bias: This is when you overinflate the value of your investments, similar to how homeowners often think their home is worth more than it actually is.
  • Herd Mentality Bias: So many investors are guilty of going with the herd on investments, whether it’s with friends, coworkers, or the media.
  • Anchor Bias: This can happen when the price of a stock shoots up or down, and an investor makes a decision to buy based on what the previous and current price is. They’re not valuing the price correctly because they’re anchoring to the higher price.
  • Illusion of Attention Bias: This is prone to happening when you invest in individual stocks, and focus all your attention on how they’re performing. This distracts you from the total performance of your portfolio.

In short, don’t fall prey to your emotions. They won’t guide you to road that leads to financial independence. Instead, base your investment decisions on sound principles, thoroughly research your options, make use of reputable resources, consult with your financial advisor, and don’t forget to enjoy life along the way.

Money is a tool to accomplish what you want in life, but don’t let the market influence your emotions to the point of being miserable.

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