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To Err Is Human (Part 2)

Cognitive errors can lead to the impression that we can take actions to beat the market, even when the odds are long.

In part 1 of this article, we looked at how to manage emotional biases, here we will look at how to overcome the cognitive errors.

Overcoming Cognitive Errors

Cognitive errors stem from poor information processing and overconfidence in our ability to predict or influence market outcomes and can lead to bad decisions. For example, resisting the urge to trade when faced with new information can be tough to overcome. But you’re likely better off not trading based on “new” information that you read in Barron’s or hear on CNBC. As everyone has access to that news, it probably won’t lead to market-beating perfor­mance. Frequent trading can lead to excessive transaction costs or realized taxes, which detract from performance.

If you find yourself trading frequently, remember there’s always someone on the other side. Consider what they might know that you don’t. It should also be sobering that most professional money managers, with all their time and considerable resources dedi­cated to their craft, don’t beat the market. Morning­star’s Active/Passive Barometer shows that most actively managed U.S. funds fail to top their average passively managed peer in their respective Morning­star Categories. Exhibit 2 shows the success rate of actively managed funds beating their passive counter­parts within their categories over varying look-back periods as of Dec. 31, 2018.

Cognitive errors can lead to the impression that we can take actions to beat the market, even when the odds are long. The good news is that cognitive errors are easier to address than emotional biases because they represent limits in logic or calculations rather than deeply seated impulses. Checking your decision-making logic and finding gaps in thinking are often the best ways to avoid making poor decisions based on cognitive errors. The following strategies may help mitigate the effects of cognitive errors.

1 | Hit pause.—Often when making an investing deci­sion, the benefits of waiting a day or a week to make a decision outweigh the penalty for not acting fast. Slowing down the decision-making process will allow the time to collect necessary information to make a more informed decision. Sometimes, the best thing to do is nothing at all.

2 | Keep an investment journal.—Documenting your thought process leading up to an investment decision can help keep yourself in check. Use consistent sections in your journal to create a time series of deci­sions to find where you consistently make strong or poor decisions.

  • For example, you could habitually overestimate the risks of an investment decision. Knowing this information could help you adapt future decisions to incorporate this known cognitive bias.
  • Keeping a journal can also help you keep track of skillful versus (un)lucky decisions. Did the decision pay off for the reasons you had anticipated or because of events that you hadn’t considered?

 

3 | Devil’s advocate.—Find a friend, financial advisor, or sibling to check your investment logic and highlight your blind spots. The goal here is to help strengthen your thinking before making the decision. The best candidates for this role are those that exhibit sound logical thinking, aren’t afraid to point out when you’re wrong, and are willing to put in the time. This is a two-way street. An investing partner will appreciate it if you exhibit the same characteristics when serving as a devil’s advocate for them.

Correcting Bad Behavior

Investors should prioritize the risk of bad behavior on their investment decisions because it’s within their control, likely to occur, and can have a meaningful impact on the odds of long-term investing success. Recognize that you’re likely to be prone to both emotional and cognitive biases. For emotional biases, improve your odds of investing success by considering a more conservative asset allocation that you can stick with during rough markets. When dealing with cognitive errors, self-reflection is key. Consider sleeping on it before making a decision, keeping an investment journal, or using a devil’s advocate when making an investment decision. Better decisions usually lead to better investment outcomes. Don’t let your behavioral biases torpedo your portfolio.

About Author Adam McCullough, CFA

Adam McCullough, CFA  

Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.