Business Insider has an informative cheat sheet about cognitive biases and how they affect our decision making. We highlight a few biases especially important to investing and wealth management.
- Anchoring Bias – Do not over-rely on the first piece of information you receive while setting your monthly investment amount (SIP), or figuring your asset allocation or setting return expectations from your portfolio.
- Zero-risk Bias – We all love certainty. To avoid even the smallest chance of losses we invest in fixed deposits or leave our money in the bank. Over long term that can have significant impact on your retirement savings. Even though uncertainty and losses are hard to deal with in the short term, the reward for taking those risks are higher wealth and better quality of life at retirement.
- Recency Bias – Do not overweight recent events in future expectations. Advisers like recommending actively managed mutual funds that have done well in the recent past (3yr or 5yr), even though there is enough evidence on the contrary. Repeated studies have shown that past out-performance does not predict future mutual fund returns. In reality the best performing funds in the past usually end up under-performing. For those more interested here is an academic paper on lack of persistence in mutual fund returns.
- Confirmation Bias – When making an investment seek out people who hold the opposite viewpoint to you. Say you want to buy an apartment in Bangalore. Talking to friends who have recently bought an apartment in Bangalore will not give you any new information – it will reinforce what you already know. However, speaking with someone who has recently passed up on buying will give you data points and lines of reasoning to think about.
- Survivor ship Bias – Do not make your decisions based on winners. Similar to entrepreneurship, investing might look easy as the media lionizes successful investors and never reminds about the many who have lost their shirt speculating. It is easy to believe that getting returns superior to the market is easy as so many have done it before. But beware, unless you are willing to work as hard as those investors or have a serious advantage in the stock market your best bet is to invest in low cost index mutual funds.
Here is the complete cheat sheet.
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