Even engineers are irrational

As engineers, one of our greatest weaknesses is a blindness to our own irrationality. We tend to think that we view the world through a uniquely analytical lens, and are immune to the cognitive biases that plague humanity.

Nope, nope, nope.

Moreover, our cognitive biases -- which evolved to be helpful in 90% of the situations we find ourselves in -- are often actively detrimental to our financial success. (Our intuition tells us to "get out of the market while it's volatile, and get back in when it's better", or to "keep dry powder in cash for an investment opportunity". Both of these lead to suboptimal investing behaviors.)

But if we're aware of our biases, we can take steps to counteract them, even as we acknowledge their influence. For example, we might create an Investment Policy Statement to keep them from pulling us off course, or we might hire a financial advisor to provide a (more) unbiased opinion (as Carl Richards puts it, "someone between us and stupid"). Here are some common cognitive biases that can afflict even the most intelligent of investors.

Anchoring

The cognitive bias of anchoring refers to our tendency to bias solutions to problems (for example, the price at which we're willing to sell an investment) on arbitrary reference points. For example, we want to hold onto an investment "until we've made money on it", rather than selling at the moment it no longer fits our IPS, or we might have a goal of a having a net worth of a million (or five or ten) before we retire, with no analysis to back it up. If we're aware of this bias, we'll be wary of choosing arbitrary numbers as goals, and look for more analytical methods of determining numerical thresholds.

Gambler's fallacy

The gambler's fallacy refers to our assumption that a certain random event is more or less likely to occur depending on whether it occurred in the past, and to see patterns where none exist. For example, if a coin flip has a result of heads ten times in a row, our intuition tells us that a result of tails is "due", despite the fact that the chance of tails remains 50%, just as it was in the beginning. Awareness of this bias will cause us to check ourselves before we assume that anything -- for example, the market value of a company in which we own stock -- will "revert to the mean".

Herd behavior

This one is just like it sounds -- we tend to be more comfortable if our choices mimic those of the group at large. This is why watching financial news channels can be dangerous; it can make it seem as if "everyone knows that it's time to sell" (or buy), when in fact you're just being exposed to a repeated opinion. Also, I find that clients tend to be more comfortable with an asset allocation similar to others of their age, despite the fact that investors of the same age may be in radically different financial positions, and thus require radically different asset allocations! If we maintain awareness of our bias towards herd behavior, we'll always double-check our reasoning when we make the "popular" choice.

Hindsight bias

With hindsight bias, we tend to think of outcomes as "obvious" even though they could not have been accurately predicted. I once met a financial advisor who remarked in passing that "there are always opportunities in the stock market, if you know where to look". This kind of theory makes sense on the surface, but the academic research is overwhelmingly against it; while in hindsight we may say, "oh, it was obvious that the subprime mortgage market was going to crash in 2008", it was clear that the majority of experts didn't predict it -- and those that did have not had a good track record since then, indicating that their prediction was more luck than skill. Hindsight bias gives us selective memory; by maintaining awareness of this bias, we'll be cautious of using "obvious" past results to predict the future.

Mental accounting

Despite the fact that a dollar is a dollar, we have a bias that treats them differently depending on the "account" they're in. Windfalls get spent on "fun stuff", rather than long-term goals. Families set aside money for long-term goals in savings and investing accounts while running up credit card debt at the same time. Investors divide their money into "play money" and "safe money", rather than treating all of their finances with care. By remaining cautious of this bias, we'll strive to reduce the "mental accounts" we create.

Overconfidence

Randall Munroe hits the nail on the head with the Engineer Syllogism. I've heard many stories of engineers, PhDs, and others who've decided to play the market, assuming that it can't be that hard. "After all, it's simple: you just buy low and sell high!" They fail to understand that simply having above average intelligence -- even very high intelligence -- is not enough to magically make consistent money in the stock market! Also, overconfidence may take the form of an "inverse herd behavior" bias, where we make decisions by specifically going contrary to the majority. (To be clear, cognitive biases notwithstanding, purely contrarian investing is not a long-term winning strategy.) By checking our overconfidence bias, we'll make sure that we're not mistaking unnecessary risk for a "sure thing".

Overreaction and availability bias

Availability bias indicates our tendency to overweight recent information, and thus overreact to it. Just because it's the latest datapoint doesn't mean it's the most important one! Warren Buffet is famous for espousing an investing strategy that borders on "benign neglect", which means knowing when not to react to news. Given availability bias, I often recommend clients compensate for it by spending less time watching talking heads on financial news stations.

Prospect Theory (loss aversion)

The idea here is straightforward: the pain we feel at a loss is more intense than the joy we feel at a gain -- we would rather gain $25 than gain $50 and then lose $25. This encourages us, for example, to sell an investment for no other reason than to "lock in" gains. This is one of the more powerful cognitive biases, to the point that most financial advisors actively allow for it in creating financial plans, in the form of risk tolerance (as opposed to risk capacity). Being aware of your loss aversion puts you in a good position to avoid taking more risk than your ulcers can handle.

How about you? Do you have any stories of times when a cognitive bias kicked you in the teeth -- or when you managed to avoid it?