Cognitive Bias: The “Stinking Thinking” That Can Cost You Money

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"I reject your reality and substitute my own." As youngsters, my kids used to quote this line from host Adam Savage of Mythbusters, one of their favorite TV shows. While he was being humorous, he was also describing the human condition.

Regardless of the facts, our perception is our reality.

This is especially true when it comes to investing, where we often make decisions based on the perceived risk we believe exists, whether or not that degree of risk really exists.

How is this relevant to you and your clients? It could cost a substantial amount of money. I base this conclusion on a 2021 study by Dalbar, Inc. It found that mutual fund investors (individuals and investment advisors) consistently earn below-average rates of return. This group’s average annual rate of return for 20 years underperformed the average (the S&P 500 index) by slightly under 2%. On a $1,000,000 portfolio, that is $20,000 a year. In the past, this gap has been as high as 5%.

The study concluded that most of this underperformance has little to do with sound investment strategy and everything to do with cognitive bias, or what psychologist Albert Ellis liked to call "stinking thinking." This is the human tendency to persistently engage with thoughts that do not serve us well. This week and next, we'll look at ten common types of stinking thinking that contribute to poor investment decisions, which typically are badly timed buying and selling.