As a psychologist with experience in the stock market, I believe I can comfortably say that there’s likely no more apt place to commence a discussion on the psychology of investing than by addressing the phenomenon of cognitive bias. You may have heard the term “cognitive bias” before, but to successfully navigate the various biases that lay in wait for us down the road, it’s time we stop to think about what they are.
A cognitive bias is essentially a systematic error in our thinking process and is usually attached to what is known as a heuristic, or a mental shortcut. Heuristics are essentially mental “rules of thumb”, which allow us to apply a broad approach to problem-solving. Put simply, they permit us to make an approximation without having to conduct exhaustive research. Our brains need heuristics to make quick sense of the vast information available to us at any given moment. Stereotyping is an excellent example of a heuristic. We see someone driving an expensive car, and we simply assume they are rich, when in fact there are many alternative explanations. Heuristics permit us to make a “good enough” approximation. BUT, there is a trade-off with the use of heuristics – while we might gain speed and parsimony in our decision-making, it is often at the expense of a more accurate decision/conclusion. This is on account of the data selected, perhaps being insufficient and thus leading us to an imprecise solution to a particular problem.
Ok, enough with the cognitive psychology waffle. How do cognitive biases and heuristics interfere with our investing? Well, whether we like it or not, our brains will try to use heuristics to make sense of the plethora of data available on any given investment. After all, our brains are just trying to be efficient and not bog us down in unnecessary detail. But we WANT detail when analysing an investment. Our brains will try and have us, for example, employ the stereotyping heuristic to expedite things, but in doing so, we lose the nuance we need to make informed investment decisions.
Early last year, Beyond Meat (NASDAQ: BYND) was listing in the US. I was busy being a psychologist, and so of course, I had no time or capacity to analyse the fundamentals behind the IPO properly. I couldn’t tell you the market cap upon listing, the earnings forecasts, which of its competitors may list in the near future, etc. I was busy, and so I wanted expediency, not nuance. So what did I do? Well, I succumbed to my brain’s heuristics, which is what happens when you trade in nuance for expediency. I simply and perhaps stubbornly reasoned that plant-based meats were clearly the way of the future for the food industry in terms of sustainability. And I was particularly cognitively biased as I was following a mostly plant-based diet at the time, so it’s clear that I had several layers of blinkers on. I was excited that the first plant-based food biotech had listed and I wanted it; simple as that. And I didn’t care about price or the fact that the stock went for USD$25 in the IPO and the cheapest I could get in post-listing was at around USD$70-90.
I should have lost money due to my using heuristics to analyse a stock, but I suspect there were countless speculators like me who just wanted in on the action, excitement, and publicity surrounding the IPO. And so perhaps I can thank my fellow speculators for pushing the price up to as high as USD$234 and enabling me to lock in some profits along the way when by all rights, I should have been punished for my lack of rigorous research and general unpreparedness. Indeed, the stock has since seen lows of around USD$60, and so I could easily have lost money on this trade. But perhaps I can at least blame my brain’s instinctive tendency to employ heuristics for leading me astray? Whatever the case, it’s important we always maintain an awareness of our brains’ natural inclinations and how these can lead us astray when it comes to stock market investing.
