Learn how successful investors avoid cognitive traps and build a winning mindset.
It turns out there’s some good evidence to support him.
The hard truth is that despite a profitable long-term upward trend in the stock market, the average investor performs quite poorly.
Unfortunately, there’s a lot of evidence showing the average investor gets tripped up by common mistakes which really hurt his long-term profits.
Look first at this chart which shows how the average investor has performed vs. a range of other investment classes over the last 20 years.
As you can see, the results are not good. The average investor underperforms nearly every asset class on the market and just barely outpaces inflation.
Now, let’s take another view.
How does the average mutual fund investor perform vs. the S&P 500:
Looking at the red bars (the average investor) vs. the green bars (the S&P 500), the average investor has constantly trailed the performance of the S&P 500 by a wide margin.
What’s especially surprising about this graph is that even with mutual funds, when the stock picking is done by the pros and the investor has no input, investors still perform poorly.
How is this possible? Why does the average investor perform so poorly?
The biggest mistakes that hold investors back can be categorized into five major areas:
While I could dig into each of these specific mistakes, I believe that these, and many others, are driven largely by underlying cognitive traps.
It’s much more impactful to focus our energy there.
They cover a wide range of decision making, belief, social, memory, and behavioral biases.
What Is a Cognitive Bias?
Let’s start by understanding what a cognitive bias really is.
A cognitive bias is a systematic pattern of deviation from rationality in judgment.
In the context of stock market investing, a cognitive bias is a pattern of irrational decision making that leads to a suboptimal outcome.
Put simply, cognitive biases are predictable mental mistakes that lead to poor results.
For each of the 12 cognitive biases discussed below, I provide three important insights:
- What is it? (A simple explanation of the cognitive bias.)
- How does it apply to investing? (How this bias applies to investing, with examples.)
- What should you do instead? (How to think instead, so you don’t fall victim to this bias in the future.)
Click on any article to learn how to recognize and avoid the cognitive bias:
The disposition effect is the tendency of investors to hold onto assets that have lost value and sell assets that have gained value.
The sunk cost fallacy is when investors justify additional future investment in something because they’ve already invested a meaningful amount into it, despite evidence suggesting this decision is probably wrong.
Loss aversion is the tendency of investors to find losses much more painful than equivalent gains are delightful. Put another way, the pain of losses is much larger than the pleasure of gains.
The endowment effect is the tendency of investors to value stocks they already own as more valuable than they really are.
The bandwagon effect is the tendency of investors to do or believe things because many other people are doing or believing the same thing.
Authority bias is the tendency of investors to give more weight and influence to the opinions of people in authority, believing them more likely to be correct.
Narrative bias is the tendency of investors to view investments through the lens of a narrative, forming a simple story and ignoring data that doesn’t fit the story.
Confirmation bias is the tendency of investors to search for, interpret, focus on, and remember information in a way that confirms their original point of view.
The familiarity effect is when investors take a liking to something simply because they’ve been exposed to it. Also called the “mere exposure effect,” it means that being familiar with something makes you favor it.
The gambler’s fallacy is the tendency of investors to think that future probabilities are somehow altered by past events, when in reality they are unchanged.
Recency bias is the tendency of investors to focus on recent trends and events, and unjustly assume they are more likely to happen in the future.
The law of the instrument describes an investor’s tendency to overly rely on familiar tools, methods, or strategies while undervaluing other approaches. This bias is commonly known as, “If all you have is a hammer, everything looks like a nail.”