“The first principle is that you must not fool yourself and you are the easiest person to fool.”
– Richard Feynman, physicist
The above are sage words from the late American physicist Richard Feynman. Although he mentioned it in the context of science, as investors we should take his advice and make sure we don’t fool ourselves when making investment decisions. It’s important to be humble and aware that we can fall prone to a host of behavioral biases that could lead us down a path of destructive decision-making. In this post, we’ll look at some biases along with examples so we can become better investors.
I’ve been guilty of these biases at one time or another and sometimes I didn’t even realize it. Being aware of this has hopefully made me a more logical and rational investor.
Behavioral finance has become an enormous area of study. Investors, like any humans, are prone to bias. Most investors aren’t rational in making decisions. They let emotional and faulty reasoning get in the way of sound decision-making. Nature bestowed emotional bias upon humans to help us survive. Unfortunately, these biases can turn us into horrible investors. The key to becoming a better investor is to become aware of the various biases that we can have. By doing this, we hope to make more rational investment decisions.
Behavioral biases fall into one of two categories:
Cognitive biases or errors come from faulty analysis, reasoning, or bad informational processing in making investment decisions. It could come from the failure of an investor to incorporate new information in making an investment, performing incorrect statistical analysis, performing an investment valuation incorrectly, or something to that effect. These errors are easily corrected because the source of the error can be quickly identified, understood, and it comes from a logical standpoint.
Emotional biases are those that stem from feelings, intuition, or perceptions from a mental state that isn’t logical. These are much harder to correct because these biases occur unconsciously within us. Often, we aren’t even aware of it! Emotional biases come from the part of our brain that relies less on logic but rather instinct or “gut feeling.” These are a result of our basic survival and impulsive instincts. While these may serve us well in certain parts of our lives, when making logical investment decisions, these emotional biases can be hazardous to our financial health.
Let’s look at the various cognitive and emotional biases along with some examples.
Some cognitive biases / errors are as follows:
1. Conservatism Bias: This is when people maintain a hold of their beliefs despite new evidence and information coming up that could change the original hypothesis. It’s also another term for cognitive dissonance, where’s one’s view of the world is so entrenched in the mind, that any evidence to the contrary that may change the state of things is ignored, or some excuse is made for why the person’s original hypothesis is still correct. For example, an investor fails to update his revenue forecast for a company when a report comes out stating that industry demand for the company’s product is falling.
2. Representativeness Bias: This happens when people take information and classify it into categories based on their past experiences. They may not realize that the information is too small of a sample to accurately categorize and rely on. For example, an investor analyzes a few stocks in Japan and sees that their balance sheets are all high in cash and low in debt. If the investor concludes that mostly all Japanese companies are cash rich and low in debt and therefore less risky, he may be guilty of representativeness bias.
3. Confirmation Bias: This bias arises when people look for and process only the things that justify their current beliefs while ignoring evidence that is contradictory to their beliefs. For example, an investor is bullish on a company because of its growth rate, but ignores the risk of the company’s sizable long-term debt.
4. Hindsight Bias: “Hindsight is 20/20” as the saying goes! Or, “It’s easy to be a Monday morning quarterback!” This bias occurs when people see past events as being more obvious and easily predicted than they really were. This could lead someone to believe that future events can be easily prophesied. For example, an investor looks at a past stock market crash and sees that the factors leading up to it should’ve been perfectly obvious. This may give the investor a false sense of confidence that he can predict the next market crash.
5. Illusion of Control Bias: This happens when people believe they have control over the outcomes of events, decisions, or investments. For example, an investor fails to properly diversify his portfolio because he sits on the board of directors of one of the companies he’s invested in. He may be overestimating the extent to which his presence can influence the success of the company.
6. Framing Bias: This bias occurs when people process information positively or negatively based on how a statement is framed. It also occurs when people just focus on one or two factors when making a decision instead of all factors. For example, an investor listens in on a company’s earnings conference call. The management states that the company’s revenue increase of 30% year-over-year is the highest it’s been in two years. However, the investor may fail to realize that the company’s revenue over four years is down 50% and their debt has doubled. He’d be guilty of falling for framing bias in this case and may be over-exuberant about the company’s prospects.
7. Anchoring Bias: When people need to estimate unknown numbers, they tend to come up with initial estimates based on past experiences and stick to these arbitrary points. For example, an investor performs a discounted cash flow analysis and assigns a growth rate to the stock that he’s used in the past for similar companies. If he sticks to his growth rate estimate even as contrary evidence arises, he would be guilty of anchoring bias.
8. Availability Bias: This happens when people use experiences in their most recent memory to estimate the probability of an outcome. Since our brains remember information best that’s most recent, we may give undue emphasis on recent events to predict future outcomes. People may also use heuristics or “rules-of-thumb” when making decisions and not account for all factors. For example, an investor most familiar with technology stocks sees the high growth rates and stock price increases over the past decade. He observes them as successful investments. He may incorrectly assume that technology stocks will continue to exhibit superior returns going forward and fail to properly diversify or consider investments in other sectors.
Some emotional biases are as follows:
1. Loss-Aversion Bias: This bias is a result of people’s natural tendency to prefer avoiding losses than to maximizing the potential for gains. For example, an investor may own a stock that’s been a loser for years. He sees more attractive investment opportunities, however he doesn’t sell the stock because he doesn’t want to lock in a loser. In this way, he irrationally is foregoing potential gains in order to avoid the pain of loss. Another example could be when an investor has a stock that’s shown gains and he quickly wants to sell to avoid giving back his profit. Doing this, he could be missing out on potential upside profits. The old investor’s maxim, “cut your losses short, and let your profits ride”, is as true as ever, but much easier said than done because of loss-aversion bias.
2. Status quo bias: One of the laws of physics is that an object at rest wants to stay at rest unless acted upon by another force. Similarly, people generally don’t like change. They prefer the status quo and for things to continue as they are. Change implies uncertainty and that can scare people. For example, an investor may have a portfolio with certain risk characteristics that were appropriate for him many years ago, but as the years went on and his circumstances changed, he refused to change the makeup of his portfolio. This could have undesirable consequences for his financial well-being, but status quo bias keeps him from acting because he doesn’t like change.
3. Overconfidence Bias: This bias is pretty straightforward. People are generally overconfident of their abilities to predict events, estimate probabilities, and perform proficient non-biased analysis. Investors may mistakenly attribute their correct calls as skill and their mistakes as due to bad luck.
4. Endowment bias: This bias is naturally occurring because people value and hold attachment to the things they own. For example, an investor may have held a stock for 20 years and calls it “his baby” that he’ll never sell. In this way, he’s become emotionally attached and isn’t considering whether it’s rational to hold the stock or if there’s better investments to consider. Another case could be when people inherit investments from their family. They may be wary to ever change the makeup of their inherited portfolios because there’s an attachment there and they don’t want to sell what was passed down to them. In these cases, the maxim applies that one should never “get married to stock.”
5. Self-Control Bias: This occurs when people act in manners that benefit them in the short-term but don’t consider the long-term benefits. People prefer short-term satisfaction that occurs instantly rather than wait for a greater reward in the distant future. For example, an investor that’s having a bad year may invest in riskier stocks that have the potential for quicker short-terms gains to make up his recent losses, rather than wait for a prudent investment in a company that could provide compounding returns over the long-term.
6. Regret-Aversion Bias: This occurs when people fail to make decisions because they don’t want to experience the pain of regret if they are wrong. Yet this has the result of people becoming emotionally paralyzed from making a decision at all. For example, an investor who’s suffered losses in the past may not want to invest in the stock market if it’s crashing because he’s scared of further losses. Yet often these tend to be the best times to invest. Similarly, an investor may not want to buy into a stock market that’s making new highs because he fears he’ll experience regret if he buys at the top.
7. Bandwagon Effect Bias: This occurs when people are influenced to buy a product, invest in something, join a group, or adopt an idea because they see others doing it. There’s an inherent desire in most humans to follow the crowd and mimic the actions of others. This stems from the fear of missing out on something, or not being accepted into a group because we’re different. For investors, illogically following the crowd can have consequences disastrous to their financial health. For example, an investor may see that his peers and other investment funds have been piling into biotechnology companies because of recent bullish analyst reports. Because the investor may be judged according to how he performs relative to his peers, he may “not want to miss the boat” so he invests in the same stocks his competitors do. In this way he may be guilty of bandwagon effect bias. (If he doesn’t have a prudent reason to invest in those stocks other than the fact others are doing it.)
That concludes our list of behavioral biases. I’m sure that more exist but I think I’ve covered most here. We’ve all been guilty of a few at some point, whether as it relates to investing or in other areas of our lives. Hopefully by being aware of where our natural human biases exist, we can at least be aware of them, and make better decisions while investing and while living life.