Happy Independence Day!
I wish you a pleasant day of friends and family as we celebrate 249 years of our nation.
While the action in Salem focuses on witch trials and Halloween in October, in July, attention turns to the sea, the beaches, and the maritime history of our city. The view above is of the Winter Island lighthouse standing guard over the mouth of Salem Harbor. And in just a few days, our harbor will be serenaded by the sounds of bands and then illuminated with the light of exploding fireworks.
In recent columns, I’ve weighed in on what I see as external threats to your investing success—tariffs and the national debt crisis. Today, I’m addressing an insidious internal threat. However experienced and skilled an investor you are, that threat is you.
Let me explain.
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Individual investors are often hindered by their cognitive biases—systematic patterns of deviation from rational judgment—that can lead to suboptimal investment decisions and reduced long-term returns.
A cognitive bias is a systematic error in thinking that affects how people perceive, remember, and make decisions. These biases often occur because our brains use mental shortcuts—called heuristics—to process information quickly.
Cognitive biases are innate. If you are human, you have them, and as far as I know, it’s impossible to get rid of them. They came along with our evolution because it turns out that they are enormously helpful in keeping us safe and alive in many situations. But, like most good things, they have their limit.
Human evolution favored the survival of early humans who developed and used these heuristics. While these shortcuts are useful, they can lead us to make irrational or inaccurate judgments.
While we may not be able to fully shake these biases, we can train ourselves to be less vulnerable to them. Being aware of these biases and understanding them is your best defense against succumbing to the negative aspects.
The Cognitive Biases That Undermine Investors
The list of cognitive biases is long, but there are several that are particularly common that affect investors. These include:
Overconfidence Bias
Investors frequently overestimate their knowledge, skills, or ability to predict market movements. This can lead to excessive trading, taking on too much risk, or ignoring contrary evidence. For example, many believe they can consistently outperform the market, despite data showing that only a small fraction of active managers do so over time.
Key effects: Overtrading, underestimating risks, and ignoring professional advice.
Herd Mentality (Bandwagon Effect)
This bias arises when investors follow the crowd, making decisions based on what others are doing rather than independent analysis. It’s often driven by fear of missing out (FOMO) and can lead to buying at market peaks or selling in panics, contributing to bubbles and crashes. The herd mentality is what causes investors to buy a stock after a big run-up or dump it after it has corrected.
Key effects: Chasing trends, buying high and selling low, amplifying market swings.
Loss Aversion
Investors feel the pain of losses more intensely than the pleasure of equivalent gains—often described as losses feeling “twice as painful” as gains feel good. This leads to holding on to losing investments too long (hoping to “get back to even”) since selling just makes the paper loss real. This can also cause us to sell winners too early. Either way, this aversion can drag down your portfolio performance.
Key effects: Holding losers, selling winners prematurely, reluctance to realize losses.
Anchoring Bias
Investors anchor to initial information—such as a stock’s purchase price or previous high—and base subsequent decisions on this reference point, even when new information suggests a different course of action. This can prevent rational reassessment of investments as circumstances change.
Key effects: Fixation on past prices, ignoring current fundamentals, delayed decision-making.
Confirmation Bias
This is the tendency to seek out or overvalue information that confirms existing beliefs, while ignoring or dismissing contradictory evidence. Investors may become blind to risks or warning signs, leading to poor decisions and missed opportunities for course correction.
Key effects: Selective information gathering, reinforcing existing positions, ignoring red flags.
Status Quo and Familiarity Bias
Many investors prefer to stick with what they know (familiar stocks, home-country markets) or avoid making changes to their portfolio—even when adjustments are warranted by changing circumstances. This can lead to under-diversification and missed opportunities.
Key effects: Inertia, under-diversification, resistance to beneficial change.
Regret Aversion and Disposition Effect
Regret aversion leads investors to avoid taking actions that could result in feeling regret, such as selling a losing investment. The disposition effect, closely related, is the tendency to sell winners too soon and hold onto losers too long, often to avoid admitting mistakes.
Key effects: Inaction, missed tax benefits, and suboptimal portfolio turnover.
Recency and Availability Bias
Investors give undue weight to recent events or easily recalled information, believing that what’s happened lately will continue. This can cause overreaction to short-term market moves and poor long-term planning.
Key effects: Overreacting to recent news, trend-chasing, neglecting long-term strategy.
| BIAS | DESCRIPTION/EFFECTS |
| Overconfidence | Overestimates skill, excessive risk-taking |
| Herd Mentality | Follows the crowd, amplifies bubbles/panics |
| Loss Aversion | Holds losers, sells winners too soon |
| Anchoring | Fixates on initial price, ignores new data |
| Confirmation Bias | Seeks confirming evidence, ignores contradictions |
| Status Quo/Familiarity | Avoids change, under-diversifies |
| Regret Aversion | Avoids realizing losses, inaction |
| Recency/Availability | Overweights recent events, trend-chasing |
To maximize your chances for success, I recommend these simple steps:
- Develop and follow a disciplined investment plan.
- Regularly review and rebalance your portfolio.
- Seek diverse perspectives and challenge your assumptions.
- Focus on your developments that affect long-term goals, not short-term noise.
- Working with outside guidance from an investment analyst or advisor can help you develop and stick to a plan.
Recognizing and mitigating these cognitive biases is essential for making rational, objective, and ultimately more successful investment decisions.
For your investing success,
Ed Coburn
President, Cabot Wealth Network
P.S. If there is a topic you’d like me to cover in future articles, please let me know. I also very much welcome your comments, questions and suggestions so please feel free to reach out to me anytime.
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