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Top 10 Investor Errors: Cognitive Deficits

Posted By Barry Ritholtz On July 7, 2012 @ 9:00 am In Apprenticed Investor,Investing,Psychology | Comments Disabled

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



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

Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2012/07/top-10-investor-errors-cognitive-errors/

URLs in this post:

[1] Excess Fees: http://www.ritholtz.com/blog/2012/06/top-10-investor-errors-fees/

[2] Reaching for Yield: http://www.ritholtz.com/blog/2012/07/top-10-investor-errors-reaching-for-yield/

[3] You Are Your Own Worst Enemy: http://www.ritholtz.com/blog/2012/07/top-10-investor-errors-you-are-your-own-worst-enemy/

[4] Asset Allocation vs Stock Picking: http://www.ritholtz.com/blog/2012/07/asset-allocation-vs-stock-picking/

[5] Passive vs Active Management: http://www.ritholtz.com/blog/2012/07/top-10-investor-errors-passive-vs-active-management/

[6] Mutual Fund vs ETFs: http://www.ritholtz.com/blog/2012/07/top-10-investor-errors-mutual-fund-vs-etfs/

[7] Neglecting the Long Cycle: http://www.ritholtz.com/blog/2012/07/investor-errors-neglecting-long-cycles/

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