Our minds are wonderful things, and by and large they serve us pretty well to get us through life. Through a combination of "common sense" and basic learning, we are able to negotiate most of life's decisions, both small and large.
But there are some areas where our minds may let us down by jumping to the wrong conclusions too quickly...the term "cognitive bias" describes a tendency in our thinking that may lead us away from a rational or well reasoned conclusion. While cognitive biases exist outside of the realm of financial management, they definitely do show up consistently in the way people approach their money matters.
I have saved a link on my browser to this collection of types of cognitive bias and I make a point of reviewing them on a regular basis to remind myself of the dangers in easy thinking. The list is not exhaustive, and there are other labels given to some of these concepts in other places, but image serves as a handy reference.
One particular bias not named on that picture but that comes up often in finance is "confirmation bias". This bias shows up when a person has an idea or hypothesis, but only see supporting or confirming data while systematically overlooking or discounting contrary data. Basically, we like to be right, so the evidence that supports our thoughts is more attractive and tends to weigh more heavily in our own estimation than evidence that we may not be right. This bias can affect decisions to buy a specific investment or follow a particular strategy...for example an investor may see an ad for Coca-Cola while researching stocks and think "hey, maybe I should buy some Coke stock". While doing research on the company, they may then see an article mentioning that Warren Buffet likes Coca-Cola stock for his portfolio and - bam! - the investor may now feel that their thought is confirmed by Warren Buffet's opinion. The danger here is that each investor has a highly individual situation that ought to influence their view on risk, holding periods, diversification, etc. Coke stock may be a good fit for them or not, but the decision should flow from an understanding of their situation and that of the company, not whether a third party likes the stock for their portfolio.
I should point out that cognitive bias does not necessarily lead to wrong conclusions, but may simply result in decisions that have not been fairly or thoroughly considered due to some shortcuts that our minds make (whether we are aware of those shortcuts or not!)
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David R Wattenbarger, president of DRW Financial
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