Investing Blind Spots: More Than Meets The Eye

Sky watchers in North America will be counting on getting an eyeful when the next total solar eclipse happens late this summer. We've all heard the warnings about never looking directly at the sun — thanks mom and dad! — but there are lots of people out there who don't heed those words of wisdom during solar eclipses.

Let's just say some people have a "blind spot" when it comes to taking a peek at the moon blocking the sun without protecting their peepers. They've heard the warnings but don't think they apply to them (it's not that bright from here!), or they get caught up in the excitement of the moment and "forget" the rules. The same can go for how we handle investments. Novice investor or professional, we all have blind spots. They're the cognitive (errors of memory and miscalculations) and emotional (based on feelings) biases that can cause us to make irrational decisions. Think any of these common biases affect you?

Cognitive Biases in Action

Anchoring: How tall is Mount Everest? Not sure? If I threw out a number — say 8,000 metres — as an "anchor," your answer is likely to be near it. (Correct answer is 8,848 metres, but it's said to be shrinking!) With anchoring, we tend to rely too heavily on that first piece of information given to us as a reference point. It's like investing in a company only because its shares have fallen from their 52-week high without considering any other fundamentals.

How to Counter: Consider taking time to reflect on your choices and seek other perspectives — ie. alternate reference points

Overconfidence: Ever read a tip about a company and then convince yourself that you've got more, or better, information than another investor and should take action right away? Or maybe you've chalked up a recent successful investment to your "magic touch." That could be overconfidence at play. It can lead to over-trading, riskier investment choices and less diversification.

How to Counter: Remind yourself that you can't know everything when it comes to how an investment may perform. It's tempting, but try to avoid over-checking your portfolio and be cautious of getting emotionally attached to an investment. Instead, start with an asset mix that's right for your time horizon and keep in mind an occasional portfolio rebalance can keep your asset allocation in line.

Confirmation Bias: When our version of reality doesn't match up with the facts, we'll knock ourselves out to bring back alignment. When this bias is in play, we tend to look to confirm our initial impressions, even if there's information to the contrary. If we think a company is the best blue-chip in the world and then they release some less-than-stellar news, we can still convince ourselves that it was a good investment decision.

How to Counter: Exposing yourself to others' points of view and arming yourself with additional facts can help you see many sides of a situation.

Mental Accounting: Congratulations, you won the lottery! Now you can buy that yacht. We categorize money based on how it comes to us. Employment income is treated differently than what we might call windfall money — which we tend to use for splurges. But really, it's all money!

How to Counter: A financial plan with a solid understanding of your goals can help steer you away from impulse purchases and keep your savings on track.

Recency: When an investment has a great quarter, or conversely a bad one, we're likely to over-emphasize that fact since it's fresh in our mind, which could lead us to place a bigger emphasis on risk or capital preservation.

How to Counter: Check an investment's performance over a longer period to get a stronger historical picture. One great quarter could have been an outlier in an otherwise lackluster couple of years.

Emotional Biases in Action

Endowment: Love that new car? Will never, ever own another make? The endowment effect means we overvalue what we already own. That sometimes leads to holding certain investments longer than we should.

How to Counter: Try not to fall too deeply in love with your investments. Assessing similar investments can give you an objective view of their true value.

Loss Aversion: The possibility of an investment loss pains us and we can drag our heels on selling an investment for less than we paid. With loss aversion, that emotional pain we feel from a loss far outweighs how good we feel from an equal gain.

How to Counter: Limbo — that woulda/shoulda/coulda place — can be an expensive place to hang out. Try to look at the bigger picture to help avoid acting out of fear when you might regret your decision.

Optimism: What goes up, can also go down. Those of us who are overly optimistic believe our results will be above-average and that bad things only happen to others. This can prevent us from taking risk-control measures to minimize losses.

How to Counter: Upbeat is great, but it's okay to take a moment to think about what the impact of a loss would be. Remember, risk management and investment planning go hand-in-hand.