Human Error and Behavioral Biases

A recent article in Morningstar addresses the subject of behavioral biases and how they affect investment decision-making.

“Most investors,” it says, “could improve their portfolio risk management by turning the spotlight on themselves and recognizing when their behavioral biases may lead to bad decisions that hurt performance.”

The article groups these biases into two categories: emotional biases and cognitive errors, noting that investors would be well-served to identify which they are more vulnerable to:

  • Emotional biases, it explains, come from “impulse or intuition and lead to faulty reasoning owing to the influence of feelings such as fear, greed or remorse,” adding that these are more difficult to combat than cognitive biases because “it’s tough to control emotional responses to the experience of losing or making money.”
  • Cognitive errors, on the other hand, stem from “faulty information processing or recall,” representing the limits of the human mind and therefore tend to be easier to correct than emotional biases.

The article emphasizes that all investors will fall prey to these biases at some point and that they can be difficult to overcome—particularly emotional biases that stem from impulse. That said, it offers the following steps to minimize their impact:

  1. “Hit pause:” There are benefits to waiting a day or week before making an investment decision, the article points out. “Slowing down the decision-making process will allow the time to collect necessary information to make a more informed decision. Sometimes, the best thing to do is nothing at all.”
  2. Keep an investment journal: “Documenting your thought process leading up to an investment decision can help keep yourself in check,” the article advises.
  3. “Have a devil’s advocate.” To bolster your decision-making process, the article suggests finding a friend, financial advisor, or family member to “check your investment logic and highlight your blind spots.”

The article concludes: “Investors should prioritize the risk of bad behavior on their investment decisions because its within their control, likely to occur, and can meaningfully impact the odds of long-term investing success.”