When conviction becomes a cognitive trap

Possibly the easiest part of the investing exercise is the decision to ‘buy’. You formulate multiple factors and parameters to arrive a selection from the universe. Once all or most criteria are met, it’s funneled to a focus group over which one could add further considerations based on the business prospects, some assumptions on the macros and then extrapolation of the management behavior to arrive at one or few stocks you would want to bet on.

Of course, then there’s another entire mechanism where you would build the portfolio which defines the allocation mix of each of these securities based your timelines, risk tolerance and conviction levels. Once this is done, action taken and now we’re exposed to the real-world risks, most importantly if the market too is aligned with our beliefs or not. Time is the answer and however, it varies across the investors.

So, how should we react when our initial premise is incorrect? And most importantly, do we’ve a plan to handle such a situation. In the hindsight, we feel we could’ve trimmed down our positions or completely exited, yet when the moment plays out, we hesitate. This is not just limited to investing but could be seen in our decision making even in job, at work, or even in relationships. We delay, justify and hope things amend to our choices, accumulating the losses in that process.

This is partly to do with displaying virtuousness in persistence, feeling occupied in the high ground or principles and more over quitting feels like a failure. The acceptance of failure or mistake and to course correct feels daunting as we’ve to re-do the entire process again. This is not restrictive to just investing, it’s across all walks of our life.

Each day we’ve a limited amount of cognitive energy or brain space to help make decisions. And we make thousands of small or big decision that include drafting a mail, picking the dress, choice for lunch, etc. and so by the evening we could’ve consumed most of our cognitive energy. At that point, if you were to visit a shop or browse online for shopping, we’re less able to make rational choices than that you could’ve done at the start of the day. And especially having gone through a challenging day, we ‘deserve’ an easy decision. This leads to unnecessary purchases than the need.

These along with social pressure (comparison amongst peers, friends, etc.) could have an emotional toll on the cognitive abilities which could lead to what is called Cognitive Fatigue or Depletion. It is a state of mental exhaustion and low self-control resources caused by prolonged focus, stress or making too many choices. It leads to low concentration, slower problem-solving and impulsive decision making.

There was a study conducted in 2016 at Newcastle University, assessing the effect of Cognitive Depletion on Password choice, where two groups of people were asked to generate passwords. One group was cognitively depleted while the other wasn’t. When password strength was measured and compared, a strong cognitive depletion diminishes the capacity to choose strong passwords. It is surprising that even slight exertion of cognitive effort prior to the password creation leads to stronger passwords.

So, it’s in investing or life, the most successful are those who identify these losses early and cut them short. Well documented behavioral aspects are available in investing about why we hesitate to cut losses. These include Loss Aversion: The same proportion (percentage or quantum) of loss feels inflicts disproportionate pain. For instance, a 10% loss in a position would feel more painful than the same proportion of gain.

The Sunk Cost Fallacy: Regardless of the opportunity cost (return on an alternate investment), it’s difficult to sell or move away from an invested position or relationship. This is also due to the emotional drain one could have and uncertainty to identify another such opportunity.

The Endowment Effect: We tend to overvalue the positions we own. This could be due to attachment to our thesis in finding the right selection (may also be due to past winners) and often hold these positions well past the point of value addition.

This often leads to holding on to past winners, viewing sell decisions emotionally, waiting for more info which never existed – trying to confirm the initial thesis and feeling exhausted just by the thought of revisiting the existing framework. As Kathryn Schulz puts in ‘Being Wrong’, the experience of being wrong feel identical to the experience of being right – right up until the moment you realize your error. And the transition of correction is so unsettling that it turns into personal transition.

The way to overcome Cognitive Depletion is to create a structure to the entire process of investing not just restricted around the stock selection but the exit too. Ensure that the exits are not considered as an identity dilution but an improvement. Document the process with a feedback loop to refine the process. Define and stick to stop-loss levels so that risk management is tighter.

Also, appreciate good quits, where you realize that you’ve avoided much bigger loss that could’ve hurt you if held. Follow the life routine of good sleep, physical exercise and meditation to extend the cognitive energy.

The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst firm and could be reached at info@wealocityanalytics.com