We are entering the home stretch of our 10 part series — today, we are up to number eight.

Beyond our emotions and lack of rationality, we have an entirely different set of issues that are hard-wired into our brains: Cognitive Errors.

These are the errors that are inherent in our wetware – namely, the way your brain has evolved over the millenia. Suffice it to say that capital risk decision-making was not a big issue on the Serengeti plains. On the other hand, avoiding getting eaten by lions was.

Hence, Humans have a number of unfortunate tendencies as a result. These tend to  get in our way when it comes to investing:

• We see patterns where none exist;
• We have difficulty conceptualizing long arcs of time;
• We selectively perceive what agrees with our pre-existing expectations, and ignore things that disagree with our beliefs.
• We tend to forget our losers and over-emphasize our winners.
• Our inherent optimism bias turns out to be hard-wired as well — our brains are better at processing good news about the future than bad.
• We actually get a greater thrill from the anticipation of a financial reward than the actual reward itself. (Think what this means in terms of Buy the Rumor, Sell the News)
• We seek stimulus for the dopamine high — regardless of how. Whether you are a Gambler, Alcoholic, Sex Addict, Shopaholic, or Hyper-Active Trader — its all the same buzz.
• Story-telling is how Humans evolved to share information (Pre-writing). Thus, we are vulnerable to anecdotes that mislead or present false conclusions unsupported by data.

In short, we simply are not wired for the required risk analysis inherent in investing.

These cognitive foibles that affect all of us have a significant impact on our decision making, whether we are aware of them or not.  We cannot avoid these built-in shortfalls. Its how we are made. But if you at least become aware of these processing issues, you have some hope to avoid their most pernicious impact . . .

1. Excess Fees
2. Reaching for Yield
3. You Are Your Own Worst Enemy
4. Asset Allocation vs Stock Picking
5. Passive vs Active Management
6. Mutual Fund vs ETFs
7. Neglecting the Long Cycle



Top 10 Investor Errors
1. High Fees Are A Drag on Returns
2. Reaching for Yield
3. You (and your Behavior) Are Your Own Worst Enemy
4. Asset Allocation Matters More than Stock Picking
5. Passive vs Active Management
6. Mutual Fund vs ETFs
7. Not Understanding the Long Cycle
8. Cognitive Errors
9. Confusing Past Performance With Future Potential
10. When Paying Fees, Get What You Pay For

Category: Apprenticed Investor, Investing, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

9 Responses to “Top 10 Investor Errors: Cognitive Deficits”

  1. faulkner says:

    So are we all congenital confabulators on a dopamine drip? Just as almost every culture chronicles impulsive youth, so they also recognize so-called ‘wise men.’ Those who by dint of personal effort develop themselves. They are often characterized as: taking a long view, responding with logical over emotion, and making principled decisions. Which reads like a description of someone who has contained, or at least restrained, his biases/impulses with a higher level of thinking. Certain famous fund managers may come to mind.

    With a nod to Nassim Nicholas Taleb, that so few do this should not surprise us any more than the fact a scant few become chess champions or international tennis stars – who also have a limited number of best career years. It is just that at this point we are better able to measure the mastery of sports and games than we are of market participants.

  2. Mike Radigan says:

    1. We see patterns where none exist

    I have the opposite problem. I don’t see the patterns that technicians say are there.

  3. hawleyl says:

    It’s interesting to look at CNBC and see all these behaviors. Especially interesting is their rejection of the effects of our current long-term bear market discussed yesterday. My problem is finding good information on TV for someone other than a day-trader. That’s why I’m logged-in here.

  4. constantnormal says:

    This likely also explains the persistent failure of democracies and the persistence of psychopaths in the gene pool.

    That talented liars who know exactly what to promise and how to make the pitch so as to fool the greatest numbers into giving them power and wealth would find their way to the top of government should not come as a surprise. (I’m not party-specific in this, and there is only a modest rank bias, with a lot of senators and representatives having devoted bodies of voters whose interests they trash daily, in the pursuit of more power and more money).

    The same also applies to the corporate hierarchy, in societies where the corporations have managed to suborn the competitive marketplace via purchased government influence. That would apparently include all of the so-called “developed nations”, as well as the banana republics and dictatorships and monarchies.

    Now here’s the question: Assume that at some point in the future, people learn enough about the mechanisms that make us susceptible to these errors that we are able to make strides toward correcting them, either genetically or societally. Will the upper class of psychopaths perceive a threat, step in and stop such nonsense, or will they see it as placing a few barriers to entry to their advantaged state, and encourage such activities, so long as they are never subjected to any form of a “cure”?

  5. hankest says:

    You forgot one… when presented with a list of innate cognitive deficits, we believe we’re the exceptions and not susceptible to any of them.

  6. faulkner says:

    “Cognitive Deficits” suggests our mental capacities are missing some things, and your list is a lineup of the ways in which we completely fill our every experience. Kahneman’s WYSIATI. We don’t know what we don’t know. That is, until we do.

    Growing up is a prime example of this. Very early on in life, we are concerned with what is near in time and space and emotion to us. We build out (and up) from there. Developmental psychologists have mapped these stages. Only recently has it been discovered we don’t ‘out grow’ our earlier ways of thinking. Instead, we build on them.

    As each developmental stage emerges, a new level of abilities appears. At first, these new levels are fragile and difficult to maintain. With practice and examples, they can become robust, and still, strong emotions, positive and negative, can take us back, at least momentarily, to an earlier stage/level.

    So, rather than cognitive deficits, I think it is a question of cognitive development.

  7. [...] Our brains just aren’t equipped to easily do the risk analysis that successful investing requires.  (Big Picture) [...]

  8. end game says:

    This has applications in both the investment and political realms, and where they overlap: the political leanings of your advisor and its potentially detrimental effect on your advice. The Dunning-Kruger Effect: http://rationalwiki.org/wiki/Dunning-Kruger_effect and http://en.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effect shows, for example, that those in the bottom 12% think they’re in the top 38%.
    This helps explain why conservatives think and speak so overconfidently, and how they can completely misjudge a deflationary crisis and confidently prescribe a fatal austerity. In my estimation, probably tw0-thirds of stockbrokers are conservatives, and fully applying this illusory superiority but real incompetence to your investment advice, they, as a consequence of their blind spot, misanalyzed the Fed’s response to the financial crisis as highly inflationary, recommending inflation hedges like commodities which have tanked, and getting out of long term bonds, which have soared. And for that they charge you 1% per annum, and continue to charge you 1% while your short-term bonds yield 1%. Good luck with that.


    BR: We’ve discussed Dunning Kruger many times around here

  9. end game says:

    BR: Thanks for pointing that out; I didn’t realize that.