10 Cognitive Traps That Kill Your Investing Profits

How to avoid cognitive biases and boost returns

Trading coach Van Tharp often says, “Psychology accounts for 100% of your investment success.”

A huge part of investing psychology is avoiding common mistakes.

Below are 10 cognitive traps that cost investors hard-earned money. If you can avoid these, it’ll go a long way towards boosting your long-term returns.

Cognitive Trap #1: Outcome Bias

Outcome bias is when an investor judges a past decision based on its outcome rather than the quality of the decision at the time.

For example, imagine a scenario where there are nine dimes and one quarter in a cup. While your eyes are closed, an unbiased judge randomly pulls a single coin from the cup and holds it behind his back.

He says, “If you can guess what coin I have behind my back, you get $100. If you get it wrong, you lose $100.”

What would you guess?

A dime, of course!

With nine dimes in the cup and only one quarter, you have a 90% chance of being right if you guess “dime.”

Now, imagine he opens his hand and surprisingly he’s holding a quarter. He happened to pick the coin with only a 10% chance of being selected.

If the judge now said to you, “Sorry, looks like you made a bad choice.”, that would be an example of outcome bias.

Why?

Because he’s judging you on the outcome of your decision rather than the quality of your decision at the time you made it.

Clearly, picking dime was the right choice. You had a 90% chance of being right. The fact it hit the 10% chance of quarter doesn’t mean your original choice was wrong.

If you played another round, you’d be smart to guess “dime” again. And over time, you’d win 90% of the games.

In the context of investing, the outcome bias often plays out like this:

An investor uses a proven methodology to research and pick the best possible stock based on all the information he has available.

Then, for reasons that couldn’t have been anticipated when he made his selection, the stock ends up being a poor investment. The investor criticizes his decision to buy, or worse, assumes that his methodology is flawed and abandons it.

This is often a mistake. Perhaps his methodology gives him a 70% chance of picking a winning stock, but this just happened to be one of the times his pick landed in the 30%.

While you should always improve your decision-making strategies, it’s important not to judge them only on how things turned out.

Instead, you should judge the quality of your decision based on the information you had available at the time the decision was made.

Cognitive Trap #2: House Money Effect

The house money effect is when investors take on more risk with the profits they’ve earned than they do with their other money.

Sometimes, once an investor has gained on a trade, they feel like that profit isn’t really “theirs”, so they take outsized risks with it.

This is a mistake. Whatever money you’ve earned on your investments is now yours.

$100 of investment profits is the same as $100 in your paycheck or $100 in your brokerage account.

You should aim to take the same risk with your earned profits as you do with your other funds. It’s all your money.

Cognitive Trap #3: Home Bias

Home bias is the tendency of investors to favor stocks in their home country or locality over stocks that are farther away.

We have a tendency to like what we know. And for some investors, that equates to investing in companies that are located near them.

Whether it’s in the U.S. or in their town, investors need to put all stocks on a level playing field and judge them based on sound criteria.

That said, in the case of U.S. investors, this can sometimes make sense as the U.S. is generally viewed as a larger and more stable economy than other parts of the world.

When doing your research, just be sure to ask yourself if you’re giving “home court” companies an unfair advantage.

Cognitive Trap #4: The Halo Effect

The halo effect is when investors assign the positive features of something to a company or stock based simply on their association.

For example, during the dot-com bubble, many companies raced to put references to the internet in their name, hoping it would make them seem like an exciting dot-com company.

And more recently, many companies have tried to associate themselves with cryptocurrencies or marijuana since both areas are red hot in investors’ minds.

Don’t be fooled by this. Stay focused on the underlying performance of the company rather than their flashy attempts at marketing associations.

Cognitive Trap #5: Inattentional Blindness

Inattentional blindness is when investors become so hyper-focused on certain items or ideas that they miss other things that are in plain sight.

A famous study on this phenomenon involved subjects who were asked to watch a video of people dribbling a basketball and count the number and type of passes between the players. In the background of the video, a person in a gorilla suit walked through the frame several times.

When participants were asked if they saw anything unusual, half said, “No.”

This study has been replicated in many forms and consistently people miss strange things that lie outside of the task or items they’re closely focused on.

In investing, a similar thing can happen. Investors become so hyper-focused on a certain element of their stock research (for example, is this stock growing fast enough?) that they overlook seemingly obvious items plainly within their view (for example, the stock is wildly overvalued, or the company was actually acquired last week).

While it’s good to focus on important themes and metrics, make sure to “come up for air” every once in a while and take a broad look across the horizon.

Cognitive Trap #6: The Ostrich Effect

The ostrich effect is when investors choose to ignore negative financial information to avoid the discomfort of bad news.

It’s named for the idea that ostriches bury their heads in the sand when they’re afraid.

For example, an investor may buy a stock and then one week later notice a headline that says the company is now under criminal investigation for fraud.

After putting so much research into picking the stock, and becoming so convinced it was a good investment, he doesn’t want to see the bad news. So he denies it avoids it completely.

The ostrich effect can also happen at the overall market level. Sometimes when the market starts a strong sell-off, investors will avoid watching the news or looking at their portfolio because they don’t want to see the losses.

While I don’t encourage focusing too closely on negative news, it’s important to keep an open mind and fairly consider all new information.

Cognitive Trap #7: Self-Enhancing Transmission Bias

The self-enhancing transmission bias is when investors talk with others more about their investing wins than their losses.

This gives investors the impression that others are performing better than they really are.

For example, imagine you have coffee with a friend who tells you he just sold three stocks, each for a large double-digit gain. As you leave the coffee shop, you think to yourself, “Geez, I guess I don’t do that well. Maybe I’m not so good at investing.”

The reality is that your friend didn’t tell you about the other five stocks he just sold for losses. In order to appear smart, interesting, and good at investing, he only told you about his wins.

This led you to feel like he’s a better investor than he really is, and that you are somehow underperforming.

Remember, people tend to talk more about their wins than their losses. Over time, great investors are right with only 50% — 70% of their stock picks. And the S&P 500 typically returns just 7% — 10% per year.

While it’s certainly possible to beat those numbers, you should be skeptical when others say they are vastly outperforming.

Cognitive Trap #8: Commitment Bias

Commitment bias is when investors stick with a flawed position, idea, or approach simply because they followed it in the past.

We all make mistakes. Part of the secret to successful investing is learning from those mistakes.

That’s why commitment bias can be such a deadly cognitive trap.

For example, imagine an investor who tells a friend that he’s very confident Bank of America (BAC) stock is undervalued and a great investment.

However, the very next week Bank of America reports earnings and it becomes crystal clear the company is struggling financially and is actually vastly overvalued.

Rather than reevaluate his point of view on the stock, an investor suffering from commitment bias will double down on his point of view that Bank of America is undervalued and a great stock to buy.

If he owns shares, he might watch it decline even though he knows he should dump it. Or, he might even buy more on the way down.

Once we publicly state an idea, or invest money into a strategy, or commit to something, we have a natural hesitation to back away from our position soon after, even when new information is presented that shows we may have been wrong.

Remember, it’s important to always consider all new information and evaluate your positions and strategies on a regular basis.

Cognitive Trap #9: Hindsight Bias

Hindsight bias is the tendency of investors to see past events as being more easily predictable than they really were at the time.

For example, imagine an investor who looks back at the recession and stock market crash of 2008–2009 and thinks, “Wow, there were so many clear signs of distress. If a recession happens again soon, I will definitely see it coming.”

The reality is that he didn’t see it coming. And spotting the next recession is far from a sure thing. But by looking back with full information on how the last recession played out, he’s overly confident he’ll be able to spot the next one before it hits.

Another common example is in sports. Imagine two teams match up and before the game your friend asks you to predict the winner. You say “Well, I’m not really sure, but I guess I’ll give a slight edge to Team A. I think they might beat Team B.”

As it turns out, Team A wins by a landslide, scoring a record number of points while Team B scores nothing. It’s one of the most lopsided wins in history.

Because of the stunning outcome, you may look back to when your friend asked you who will win and overestimate how confident your answer was at the time.

It’s good to look at our past correct and incorrect decisions to help us learn and make better choices going forward. But it’s important that we don’t overestimate our ability to get decisions right.

Cognitive Trap #10: Availability Cascade

An availability cascade is a self-reinforcing process in which a collective belief gains plausibility through its public repetition.

For example, let’s pretend Apple (AAPL) misses earnings due to a complex combination of these factors:

• Currency headwinds diminish sales by a few percentage points
• Many customers aren’t buying iPhones because they’re waiting for the new model which is rumored to have incredible features
• Last quarter Apple changed its rebate strategy with global retailers
• Harsh weather across the U.S. during the holiday season drove down visits and sales in Apple retail stores

However, rather than discuss the many complex reasons why Apple missed earnings, a few fast-talking analysts on CNBC float an interesting and provocative theory:

Apple missed sales because CEO Tim Cook is distracted by his interest in running for President of the United States.

(Note: This is a completely fictional scenario just to illustrate a point).

More and more people start repeating this (incorrect) theory because it sounds interesting and insightful, even though it’s completely wrong.

And now, because so many people are saying it, and everyone wants to seem like they’re “in the know” with this smart insight, it becomes a collective belief.

While the above is a specific example, availability cascades happen all the time. They’re often propagated by the media and quickly make the rounds through common culture.

Always question the reasons behind why something happened. And be especially skeptical of an overly simple explanation that everyone seems to be repeating.

Key Takeaways: Stock Investing Psychology

When it comes to profiting from stocks, simple cognitive biases can hold investors back.

No investor is perfect. We all makes mistakes. But if you keep an eye out for these common thinking patterns, your returns will improve over time.

By the way, this is a follow-on article. You can read Part One of my series on investing psychology (with 12 additional cognitive traps) here:

Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.