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Cognitive Bias: How “Stinking Thinking” Can Cost You Money

by | *Financial Awakenings, Building Wealth, Healthy Money Relationships, Investment, Money Psychology, Weekly Column | 0 comments


“I reject your reality and substitute my own.” As youngsters, my kids used to quote this line from host Adam Savage of Mythbusters, one of their favorite TV shows. While he was being humorous, he was also describing the human condition. Regardless of the facts, our perception is our reality. This is especially true when it comes to investing, where we often make decisions based on the perceived risk we believe exists, whether or not that degree of risk really exists.

How is this relevant to you? It could cost you a substantial amount of money. I base this conclusion on a 2021 study by Dalbar, Inc. It found that mutual fund investors (individuals and investment advisors) consistently earn below-average rates of return. This group’s average annual rate of return for 20 years underperformed the average (the S&P 500 index) by slightly under 2%. On a $1,000,000 portfolio, that is $20,000 a year. In the past, this gap has been as high as 5%.

The study concluded that most of this underperformance has little to do with sound investment strategy and everything to do with cognitive bias, or what psychologist Albert Ellis liked to call “stinking thinking.” This is the human tendency to persistently engage with thoughts that do not serve us well. This week and next, we’ll look at ten common types of stinking thinking that contribute to poor investment decisions, which typically are badly timed buying and selling.

  1. Fear of Missing Out. This is the concept that “the herd knows best.” Few people want to be going east when the whole herd is heading west. This is especially true when the herd is buying assets like GameStop, bitcoin, or gold. It’s all too easy to join in out of fear that you will miss out on the huge profits to be made and be left behind “holding the bag.” Usually, when the word on the street is to buy, the market in whatever asset is being hyped is near the top. The most successful investors avoid stampedes.
  2. Anchoring. This is relating something to a familiar past experience that isn’t necessarily true or applicable to the current situation. For example, a financial salesperson may compare investing in an equity mutual fund to growing a tomato plant. You put in a little seed and watch your plant grow and grow, until one day you have a bushel basket of luscious tomatoes. It’s an appealing image, but it sets an unrealistic expectation of an equity mutual fund. Neither stocks nor tomato plants grow that steadily. Some don’t grow at all. Others grow overnight and then die just as suddenly. Some get wiped out by hail. And some thrive.
  3. Action Bias. This is one I know all too well. Some of us are uncomfortable feeling anxiety, so we go into action and “do something” to relieve it. Unfortunately, “doing something” when it comes to responding to volatility in markets almost never works out well for the long-term investor. As the Dalbar study finds, the investors that trade most frequently (frequent is defined as at least once every three years) earn 2% less than those who do nothing.
  4. Media Reporting. Reacting to the financial news without a more in-depth examination can ruin the soundest investment strategy. Very few financial reporters have degrees in economics or finance. Much financial reporting is faddish, trendy, sensational, and shallow. Research suggests that investors who shun or limit their intake of financial news do better than those who don’t.

Learning to identify cognitive biases like these is an important step toward understanding and managing the emotional impulses that affect our financial wellbeing.

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