“The investor’s chief problem – and even his worst enemy, is likely to be himself”
And he’s right. Many investors since the beginning of time, have been held back by none other than themselves. Our emotions and our biases get in the way of rational thought process and proper decision making when it comes to our financial decisions.
What better way to combat this, than to take a step back to understand the possible cognitive biases we may have that may be killing our investment returns and slowing our gains. I know my blog is called TortoiseMoney and I always promote getting rich slowly and steadily but… that doesn’t mean we shouldn’t avoid these biases to avoid losses and seek greater returns!
Let’s jump right in!
Anchoring Bias refers to how we tend to place an irrational bias on psychological benchmarks, which affect our subsequent choices.
This was interestingly observed in a study done in 1974 by Daniel Kahneman and Amos Tversky. Participants were asked to spin a wheel, selecting a number at random between 0 to 100. These participants were then asked to guess how many African countries were in the UN. Those who spun higher numbers gave higher estimates while those who spun lower numbers, gave lower estimates.
In investing, we often look at a stock price and then compare it with the range that the stock price traded at in the past. This is especially so when we hold an investment where the stock has fallen in value significantly. We then expect the stock to be able to recover to its past price, without regarding if there had been any change in the fundamentals of the company or its environment.
One good example would be General Electric. General Electric’s stock trades currently in the $10+ range. However, in the past, GE stock used to trade much higher, in the low $30s. However, if an investor was holding GE’s stock, expecting it to reach those highs again, I wouldn’t hold my breath.
It’s still a massive company for sure, but revenue and margins have all shown signs of a weakening business that is in the midst of being disrupted. Revenues have steadily slid downwards by an average 7.28% per year for the last 3 years and operating margins have fallen from 37.13% in 2014 to a mere 5.68% in 2019.
Anchoring bias can hold us back from making the right financial decisions. Instead of going with our feelings, we should back our decisions with analysis of facts and fundamentals of the companies we invest in.
Loss Aversion refers to the tendency for people to avoid making losses more than seeking gains due to how the pain of losses feel twice as painful as compared to the pleasure of gaining.
This is often seen in investors who have held stocks that have fallen and simply just wait for it to rise back up because they fear the realisation of the loss by selling their stock. Now, I’m definitely not saying that all stock should be sold if they fall, but if the fundamentals change, holding a losing stock that is unlikely to return will cost you precious returns elsewhere.
This also ties in well with the endowment effect, where people tend to place more value on things that they own as compared to things they do not. In investors, this makes many investors hold their losers while they trim their winners instead to ‘take profit’.
I have seen it firsthand in my own parents. Many older Singaporean investors have probably held SPH shares at some point in their lives. Like GE, SPH has shown only falling revenues and falling margins over the recent years. However, my parents have continued to hold these investments in their portfolios despite the deteriorating financials.
“Aiya, don’t sell la, just wait for it to go back up,” they’ll say, whenever I tell them that there are better opportunities to pursue.
That is Loss Aversion in action.
Confirmation Bias refers to the behaviour where a person seeks information that confirms what they already believe, while ignoring or downplaying information which imply the contrary.
For an investor, this can be a costly mistake in doing your due diligence before investing in a company. Say for example, you heard a discussion regarding a new stock on a Motley Fool podcast. Listening to what the hosts said, they seemed pretty bullish on it. As you do your research on it, you begin to see information that confirms what you already believe of the company: High gross margins and stable growth.
But under the surface, the company could be holding crippling amounts of debt in order to sustain their growth with insufficient cash flow to pay it off.
Confirmation Bias can cloud your judgement when it comes to analysing and researching companies that we are interested in. To reduce the impact of Confirmation Bias in your investing journey, once you’ve decided why you’re bullish on the company, try actively to compile reasons why the investment may not be a good one.
Take it one step further. Even better if you have friends who are investors who can play the Devil’s Advocate and counter your arguments for the companies that you’re bullish on.
Self Attribution Bias
Self Attribution Bias is the concept that people tend to attribute their successes to their abilities and skill whereas failures are generally regarded as due to bad luck or external factors beyond their control.
In the stock market, this often translates to good trades being attributed to trading competency and failed unprofitable trades and investments being linked to market wide drops and macro factors.
But often it is hard to ascertain the role that luck plays in the good investments and bad investments we make. And because of that, it is easy to let it get to our head that our good investments are due to us being good investors. In the book, Psychology of Money, Morgan Housel describes an interview with Economics Nobel Prize Winner, Robert Shiller. In it he asks, “What do you want to know about investing that we can’t know?”
“The exact role of luck in successful outcomes.” Shiller replied.
Well so, what can we really do about this?
I think one of the key learning points here is that when you try to learn from the successes of others, focus less on the individuals and perhaps more on the broader patterns. The more widespread the pattern, the more likely that it is not as affected by luck and hence, are more replicable in our own lives.
Think about it, would it be easier to replicate a 200,000% gain from a call option buyer on /r/wallstreetbets, or to attain a comfortable 9% return on your investments via an S&P 500 index ETF.
Foresight Bias is what people mean when they say Hindsight is 20/20. It refers to thinking that something is perfectly obvious and should have been easily predicted, but only after they had seen the event happen.
This one isn’t so dangerous like the rest, but it can really mess with your mind.
2020’s stock market has continued it’s crazy volatility and rally into 2021. Every other day, if you scour on stock forums like me, you’ll probably hear about some random stocks that jump 20%, 50% or even 100% in a single night!
When you see stocks like that, it’s easy to look at the events prior and say, “Should have seen that coming!” Be it FDA approval of a new drug, new mergers and acquisitions or new contracts signed, we can’t predict everything that is going to happen. If not, we’d all be millionaires, won’t we?
Biases Are Hard to Eliminate, But We Should Try
Cognitive Biases are built into most of us as normal people and investors. It may be hard to reverse your thinking, especially after so many years thinking in a certain way. But acknowledging your biases and these pitfalls are the first step to breaking free from their grasp.
Acknowledge your biases and actively work to counter them so that you can make the financial decisions which are best for you and your portfolio’s returns.
Photo by JESHOOTS.COM on Unsplash