3 Cognitive Biases that Might Be Hurting Your Returns

How Your Mind May be Tricking You Into Bad Decisions

Getty Images / Brad Wenner.

International investing tends to be a lot more difficult than domestic investing. After all, investors must deal with currency fluctuations, geopolitical risks, and other factors that are uncommon in the United States. There are also many common risks shared between domestic and international investors, including so-called cognitive biases that can have a dramatic impact on an investor’s risk-adjusted returns over time.

In this article, we’ll take a look at three of the most common cognitive biases that investors should watch out for when building and maintaining a global portfolio. It’s important to keep in mind that these are just a handful of many cognitive biases that can negatively impact investor portfolios and its important to be aware of them in order to avoid them in practice.

#1. Gambler’s Fallacy

Gambler’s Fallacy refers to the tendency to extrapolate what happened in the past to construct an idea of what will happen in the future. The classic example of this cognitive bias is believing black is more likely after a string of reds on a roulette table. Of course, the odds of red or black is always 48% on each independent spin and gamblers would be ill-advised to bet more money on black simply because there happened to be a string of reds in prior spins.

Many investment firms are quick to disclaim that past performance is no guarantee of future results, but individual investors tend to gloss over these promises.

When it comes to international investing, it’s easy to look at falling emerging markets and assume they’re overdue for a rebound or look at lofty developed markets and assume they’re primed for a fall. In reality, most investors are best off maintaining a fully diversified portfolio.

#2. Confirmation Bias

Confirmation bias is the tendency to surround ourselves with information that validates our own point of view and ignore information that conflicts with it.

For example, members of a certain political party may ignore facts presented by the opposition and embrace what their own party says in order to validate their own point of view. The failure to consider all angles of a problem often results in poor decision making.

Investors that have purchased a security tend to surround themselves with information supporting the long position. Of course, this means that they may be ignoring short information that may have elements of truth to it. The key is to make decisive decisions based on the available information and then keep an open mind without engaging in over-trading – that is, immediately selling the security at any hint of bad news.

#3. Negativity Bias

Negativity bias is the tendency to react more to negative news than positive news, since it’s perceived as being more important in nature. For example, terrorism is often cited as a major concern for people living in the United States, despite the fact that a person is more likely to be fatally crushed by furniture than killed by a terrorist. These kinds of reactions can skew public policies and have a dramatic impact on the world.

Investors experience negativity bias all of the time and it can prove extremely costly to long-term returns.

If an investor were to sell whenever headlines turned negative, they would realize a 1% to 4% annual loss compared to those investors who held steady throughout the good and bad times, according to a wide body of research. This could end up costing investors tens of thousands of dollars for every one hundred thousand they have invested in the market.

Key Takeaway Points

  • International investing is a difficult endeavor that’s made even more difficult by a number of cognitive biases that adversely impact returns.
  • Gambler’s fallacy is the tendency to extrapolate what’s happened in the past to what will happen in the future, which can lead to bad decision making.
  • Confirmation bias is the tendency to only look at information supporting a person’s beliefs, which can be dangerous for investors.
  • Negativity bias is the tendency to react more to negative news than positive news, which can cause overtrading and reduce long-term returns.
  • There are many other cognitive biases that influence investors that they should be aware of in order to reduce the odds of making costly mistakes.