Will knowing what they are help you make better decisions?

Humans are thinking and feeling beings. We make decisions both cognitively and emotionally. As investors, we incorporate objective information, past experiences, assumptions, beliefs, and feelings—among a host of other factors—to make economic decisions. Unfortunately, we also fall prey to a variety of biases that can cause us to make faulty decisions.

Biases that are emotional in nature may be deep-rooted aversions or impulses that are very difficult to correct. They can be acknowledged and accommodated, but usually not eliminated.

Other biases are cognitive; they result from our brain taking shortcuts and making assumptions that ain’t necessarily so. A cognitive bias develops over time as we use mental shortcuts, also called heuristics, to sort through vast quantities of data and information, often without really examining it. Researchers have coined the term “innumeracy” to describe the difficulty many people have making decisions that involve large numbers or quantities and orders of magnitude (exponential increases in values).

The list of cognitive biases seems to grow every day, but here are five that are the most troubling for investors. Cognitive biases can be overcome with better information and guidance, but first you have to identify them. Here’s what they look like.

1. Self-attribution
Self-attribution is the most common bias exhibited by individual investors. When an investor’s investment decision pays off, it is seen as resulting from his or her skill and insight. When the professional money managers’ decision pays off, it is seen as resulting from proprietary trading processes and evaluation software.

On the other hand, when the investment decisions don’t work out, it’s the result of “cosmic misfortune” or other extraneous forces. As advisors, we often see this bias at work when prospective clients describe their current portfolios. They will focus on their few great decisions and dismiss the rest.

2. Hindsight
This is probably the most obvious error, and we all fall under its spell from time to time. Hindsight is the tendency to see events that have occurred in the past as more predictable than they really were at the time.

Thanks to hindsight, we all now believe we knew the tech bubble was going to burst in 2000, just as we knew the housing market was unstable. At the time, neither event was any more certain than recent predictions that gold has peaked or that the U.S. will default on Treasuries.

Hindsight bias is troubling because it leads us to believe we should be more certain about the decisions we are making today, since yesterday’s events were so predictable. In hindsight, we also forget about all the possibilities that didn’t materialize, so the actual event that did occur seems even more inevitable in retrospect..

3. Representativeness
This way of thinking is reflected in the classic adage “If it looks like a duck and walks like a duck, it must be a duck.” The more characteristics or traits of a class something displays, the more likely we are to categorize it as a member of that class.

This bias pops up whenever performance sampling is involved. Investors will often ignore the sample size when reaching conclusions about the reliability of performance results. Is a three-month return really representative of what an investor can expect for the next five years? Even the prospectus says no, but 401(k) investors will change their allocations based on three- and six-month performance returns.

4. Confirmation
“Don’t bother me with the facts; I’ve already made up my mind.” Confirmation bias stems from a natural tendency to select data that confirms our preconceived ideas and beliefs—and ignore or dismiss data that refutes them. This is the only explanation I can come up with for our ongoing arguing about active vs. passive investment styles. Of course, both sides seek out and believe research that confirms their already established preference.

5. Availability
If I can imagine it, it must be true. Availability bias causes us to believe that whatever we can most easily imagine must be the most probable outcome. For example, immediately after 9/11, people forsook airplane travel for the perceived safety of their cars. The “probability” of being killed in a terrorist attack involving planes seemed so much higher in the aftermath of trauma, yet the true probability hadn’t changed very much at all. For investors, availability bias sets in after relatively long runs of either bull or bear markets.

All of this leads us at the start of a new year to either assume 2012 will be as bad as 2011 or because last year was not a good one, it’s time to be contrarian and assume 2012 has to be better.

If there is such a thing as a holy grail, then for me it’s wrapped up in the idea that it doesn’t really matter. If you have an approach that tends to make money when things a perceived as good and tends to make money when things are perceived as bad, then what is important is sharing the message with as many people as possible. That’s what I’m doing now.