A 100 billion neurons or brain cells, interconnected with 1,000 to 10,000 other neurons, are constantly at work to define our behaviour and who we are. Collectively, the neurons create a powerful network that has the ability to learn, remember and make us do things.

Brain activity patterns can be felt and are visible through tendencies or biases. For example, most of us are pleased with praise but are pained at criticism. Our biases are subtle, yet very powerful, as they direct and force us to act and react in the same manner, again and again. Many of the biases are critical for survival and have evolved along with our minds. But some of them are also significant hindrances in critical decision-making areas such as investments. Instantaneously, retracting a hand on sensing intense heat is a lifesaving tendency (in most circumstances). But the bias to ‘herd’ and quickly follow large crowds, without questioning enough and understanding well, can bring dangerous outcomes to investment decisions.

Critical biases A number of biases affect investment decision-making. At the broadest level, biases can be categorised into two sets. Cognitive bias relates to how we think. Emotional bias, on the other hand, is based on feelings and are harder to overcome. Cognitive bias is further categorised into belief perseverance and information processing biases. The former is the difficulty in modifying beliefs despite contrary facts, while the latter identify the challenges we face in interpreting information.

There are five critical biases, from among twenty, that impact investment decision-making. Confirmation bias is our tendency to believe what we want to believe and overlook and even ignore information that is contrary to our beliefs. On downtick events, for example, we tend to sell loss-making stocks that are on a negative watch list rather easily, instead of attempting a due diligence.

Self-attribution is thinking a bit too much about one’s abilities — attributing all successes to oneself but failures to externalities. Self-attribution reinforces the tendency for confirmation.

Although classified as an “emotional” bias, our bias for overconfidence is closely related to self-attribution. Overconfidence is an unwarranted faith in our abilities across a range of skills.

Self-attribution, overconfidence and confirmation, mutually reinforce and may lead to risky investment decision-making. If we credit ourselves disproportionately, we are likely to take on more risk and, worse, never learn from any mistakes. This can increase the chance of a considerably adverse outcome in our investment decisions.

Mental accounting relates to the way we classify experiences into mental accounts that ultimately affect our decisions. We find it more difficult, for example, to gamble with earned money compared with money got by winning a lottery.

Effect of loss aversion Lastly, loss aversion is our tendency to dislike losing. We dislike losing almost twice more than winning. Behavioural finance expert and Nobel laureate Daniel Kahneman has written on loss aversion where he has shown how risky we tend to become as we lose. To quote a real-life, unfortunate, example, some ex-Lehman employees held on to most of their employee stocks even after it became very clear that it would be hard for Lehman to function as a going concern.

Biases are tightly coupled to inherited genes. Scientists have found out that our brains have neuro plastic potential — that is, they can find ways to rewire and improve on some of the inherited flaws and biases we have.

Self-discipline and focused learning can help us overcome our limitations. Better still, this will not just help our investment decision-making, but also put us in a position to bequeath a better genetic makeup for posterity.

The writer is Director – Content, India, CFA Institute

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