The human brain is an incredibly powerful processing unit. Every day we make numerous judgements and decisions – hundreds if not thousands if you conclude everything we do is an individual ‘decision’.
As the human brain has evolved, in part due to the increasing complexity of our environment, it’s developed little short-cuts, or ‘heuristics’. These mental pathways circumvent multi-stage decisions and allow us to make judgements quickly and efficiently. While heuristics are helpful and allow us to function without stopping to think about our next action, they can – and do – lead to cognitive biases. There are actually over 100 of these recognised habits1, and their mix and dominance varies from person to person.
Unfortunately, these biases sometimes trip us up leading to bad judgements and poor decisions. Consequences of sub-par decisions or erroneous conclusions are most often inconsequential but unfortunately – and consequentially - such biases exist in the full spectrum of our decision-making, including those in the realm of safety – and investing.
The investor’s chief problem – even his worst enemy – is likely to be himself - Benjamin Graham
A vital ingredient to successful investing over the longer term is knowing yourself – and specifically knowing the mental traps you may fall into when making investment decisions. So to better help know yourself, here are a few of the more typical behavioural biases of investment decision-makers.
Anchoring bias is the tendency to rely on, or anchor to, a particular piece of information, or event. There are a few common anchors for investors. Many people base their investment decisions on the current price of an asset relative to its history. Where a price is now relative to where it has been in the past is not a reliable indicator of the future direction of the price, or whether the asset might be cheap or expensive.
Another Anchor is the purchase price of an asset. While a gain or loss represents the difference between the current price and the purchase price, is this actually helpful when deciding to buy, hold or sell?
An event Anchor, with a good example being the Global Financial Crisis. Many investors, scarred by their loss of capital through the GFC, now anchor to the event (and the associated financial loss or psychological pain) when making investment decisions.
An asset should be assessed based on its intrinsic value and investors should attempt to determine an asset’s current and potential future worth in isolation from other values (or events). Disconnecting from Anchoring bias can be difficult, but a good starting point is to consider what you anchor to and when you do it.
There’s something innately safe about being in a herd. We humans are hard-wired to herd. So it’s not surprising that this is common in investment circles where investors place a big emphasis on what groups are doing.
There’s all sorts of emotions at play with this bias. There’s an element of FOMO (fear of missing out) when there’s a bull-rush to a type of investment (think tech stocks in 1999); there’s the psychological pain of going against the crowd; and then there’s the fear of humiliation or embarrassment (aside from the financial consideration) of just being proven wrong.
Recognising the lure of running with the pack requires an ability to think independently. Be self-aware about the social and emotional pull of the herd. If this is confusing or overwhelming, then consider using a professional investment manager to dislocate you from this pull.
Confirmation bias is the tendency of people to pay close attention to information that confirms their belief, and ignore information that contradicts it. This can be lead to overconfidence and the risk of being blindsided.
Our natural tendency is often to listen to people who agree with us. It feels good to hear our opinions reflected back to us. Many people choose their news sources based on a confirmation bias. Do your news sources reflect your views and opinions? There’s nothing particularly wrong with this per se, but such bias can be disastrous for investors, as it can validate and reinforce a view which may be flawed. Instead, we should be looking for disconfirming information to test against an initial view. A discipline of stress-testing and deconstructing ideas runs consistent in many of the world’s most successful investors. To overcome this bias start looking for information that might disprove your ideas, rather than confirm what you want to do.
People tend to overestimate their skills, abilities, and predictions for success. This bias is prolific in behavioural finance. Careful risk management is critical to successful investing and overconfidence tends to make us less cautious in our investment decisions. Many of these mistakes stem from an illusion of knowledge and/or an illusion of control.
Anecdotally, a significant number of SMSF-holders suffer from overconfidence bias. Asset allocation data collated by the ATO suggests the average SMSF is highly concentrated in domestic assets (particularly shares and cash), poorly diversified and consequently exposed to various material risks.
Overconfident investors often put down their wins to talent and losses to plain bad luck. Guarding against overconfidence involves acute self-awareness and the ability to isolate the role of skill versus timing, or luck.
Loss aversion is a tendency to dislike losing money a lot more than enjoying making money. This kind of bias is commonplace with stock traders, but definitely also applies to longer term investors. The GFC is a period in many investors’ lives which created an enduring fear of substantial loss. Scarred by losses from such periods, investors can be at risk of creating portfolios too conservatively invested with a primary goal of fortifying against loss, rather than looking at their time horizon and structuring a portfolio to suit.
Conversely, there is a new cohort of younger investors whose entire investing experience has been after the GFC, creating hubris around investing skill (see overconfidence) and a portfolio structure which may take on too much risk on the belief that markets will rise in perpetuity. Investors need to remember that to generate a certain level of returns they need to take a certain level of risk, and periods of negative returns are to be expected when taking on risk. The idea is to not take excessive risks in seeking to achieve a return goal.
What are your biases?
What, of the list above might you be most prone to? Can you ascribe one or more biases to an investment mistake? Perhaps write down the three that you think you are most susceptible to. (Remember that there are many more.)
Common to a lot of these biases is the ability to think independently. And if you can’t do this, or don’t have the time and energy, then consider employing a professional investment manager to do it for you. The best money managers are acutely aware of their biases and actively guard against them by slowing down and testing decision drivers before transacting.
From an evolutionary perspective, mental short-cuts are great but successful investing relies on the application of sound judgment and control over emotions and natural tendencies. Being aware of these academically-proven behavioural biases and how they influence your investment decision-making processes can help with realising long term financial goals.
1 - https://en.wikipedia.org/wiki/List_of_cognitive_biases