Investment Biases that every Investor must avoid
A stock or other investment, according to proponents of efficient markets, already has all available information. The growth of algorithmic trading, according to efficient market theorists, has made information processing in market prices practically instantaneous. Others, on the other hand, have their doubts. Long-term investors of the caliber of Warren Buffett and high-frequency traders, they argue, profit from market inefficiencies. They claim that because markets are made up of humans or computers programmed by humans, inefficiencies are inherent.
Behavioural biases influence people’s financial decisions, causing them to act on emotion or make mistakes while processing data, regardless of how disciplined they are. This is the cornerstone of behavioural finance, a branch of study that combines psychological theory with traditional financial economics. These factors are used in behavioural finance to predict actual trading behaviour, which is then used to design more efficient trading algorithms that take into account human limitations.
1. Confirmation bias
Confirmation bias is a natural & innate human tendency to seek out or emphasise evidence that supports an existing conclusion or theory. Investors grow overconfident as new data appears to corroborate their previous beliefs, which we believe is a major cause of financial errors. This arrogance might lead to the false belief that nothing will go wrong, leaving you vulnerable to being caught off guard when something does.
We try to challenge the established quo and seek material that makes us doubt our investing thesis to reduce the risk of confirmation bias. In reality, we are constantly attempting to flip the investing case in order to determine why we may be incorrect. We evaluate our investment case on a regular basis and question our assumptions. It’s far more important to consider why you’re wrong than why you’re right. “Rapid destruction of your ideas when the timing is right is one of the most valuable abilities you can have,” Charlie Munger, Berkshire Hathaway’s Vice Chairman and Warren Buffett’s business partner, said. You must force yourself to consider the opposing viewpoint.”
As Carl Jacobi, the famous 19th century mathematician, said: “Invert, always invert.”
2. Information Bias
Information bias is the innate tendency to evaluate & judge information even when it is unrelated to understanding a problem or issue. The key to investing is evaluating information that is critical to make a more informed investment decision while rejecting (and presumably ignoring) irrelevant data. Every day, financial analysts, newspapers, and stockbrokers bombard investors with worthless data, making it tough to sort through it all and focus on what counts. Daily share price or market movements, in our opinion, typically provide no information that is beneficial to an investor concerned about an investment’s medium-term prospects, despite the fact that entire news shows and financial sections are dedicated to analysing swings on a moment-by-moment basis.
In many cases, investors will buy or sell an investment based on short-term fluctuations in the share price. This can lead to investors selling great investments because the share price has dropped, and buying bad investments because the share price has increased.
In general, investors would make better investment selections if they ignored daily share price changes and instead concentrated on the underlying investment’s medium-term prospects and compared the price to those possibilities. Investors should avoid a serious source of information bias in the investment decision-making process by disregarding daily discussion on share prices.
3. Loss Aversion / Endowment Effect
People’s strong preference for avoiding losses over gaining gains is known as loss aversion. Loss aversion is intimately linked to the endowment effect, which happens when people place a higher value on a thing that they own than on an equal commodity that they do not own. The endowment effect which is also known as loss aversion, can lead to irrational investment decisions, in which investors refuse to sell lost investments in the hopes of recouping their losses.
The loss-aversion tendency violates one of economics’ core laws: the appraisal of opportunity cost. You must be able to effectively evaluate opportunity cost and not be tethered to previous investing decisions due to our natural drive to avoid losses to be a long-term successful investor. Investors who are afraid of losing money will pass up profitable investment opportunities in order to keep a failing investment in the hopes of recouping their losses.
All previous decisions, are sunk costs, and whether to keep or sell an existing investment must be weighed against its opportunity cost. This forces us to consider the opportunity cost of keeping an existing investment vs adding to the portfolio with a new investment. Many investors, would make better investing decisions if they limited the number of investments in their portfolios because they would be forced to consider opportunity cost and make trade-offs. Warren Buffett frequently uses the analogy that investors would have better long-term investing performance if they had an imaginary punch card with only 20 holes on which they had to punch every time they made an investment during their career. According to Buffett, this would drive investors to consider the investment carefully, including the dangers, resulting in more informed investment selections.
4. Incentive-caused Bias
The influence of rewards and incentives on human behaviour, which can lead to foolishness, is known as incentive-caused bias. The subprime mortgage crisis of 2008 in the United States is a textbook example of incentive-driven bias. Despite the fact that bankers were aware that they were providing money to borrowers with poor credit records, and in many cases, persons with no income, jobs, or assets (‘NINJA’ loans), a whole industry based on lending to such people was developed.
There were incentives in place at nearly every level of the value chain to encourage people to engage. The developers had a significant financial motive to build more homes. Mortgage brokers had a vested interest in finding clients to take out loans. Investment banks have a vested interest in paying mortgage brokers to originate loans so that they could package and securitize them for resale to investors. Rating agencies had a strong incentive to grant AAA ratings to mortgage securities in order to earn fees, and banks had a strong incentive to buy these AAA-rated mortgage securities because they needed little capital and yielded massive, leveraged profits.
“Nothing sedates rationality like massive dosages of easy money,” Buffett observed. After a mind-blowing encounter like that, ordinarily rational individuals start acting like Cinderella at the ball. They understand that prolonging the party — that is, continuing to speculate in companies with exorbitant valuations compared to the cash they will likely create in the future – will inevitably result disaster. Nonetheless, they don’t want to miss a single minute of what is sure to be a wild celebration.
We investigate whether the current incentive and reward systems are likely to motivate management to make logical long-term decisions. We favour companies with incentive plans that incentivize management to return excess capital to shareholders and focus management on the downside as well as the upside. For example, excessively skewed executive compensation toward share-option plans can encourage behaviour that is detrimental to shareholders’ long-term interests
5. Oversimplification Tendency
Humans have a natural desire for clear and straightforward answers while trying to understand complex issues. Unfortunately, certain issues are intrinsically complex or unknown, and straightforward answers are not possible. In fact, certain issues are so hazy that it’s impossible to predict the future with any certainty. Many investment blunders, are caused when consumers oversimplify ambiguous or complex issues. As Albert Einstein once said: “Make things as simple as possible, but no more simple.”
Effective investment necessitates staying inside your ‘circle of competence.’ We should not invest if we cannot comprehend the intricacy of a business, no matter how convincing the’simplified’ investment case appears to be.
Unfortunately, these cognitive biases are “hard wired,” which means we will continue to make mistakes. Our goal is to create systems and processes that reduce the number of errors we make as a result of our cognitive biases.
6. Hindsight Bias
The propensity to interpret positive previous occurrences as predictable and unfavourable events as unpredictable is known as hindsight bias. Many causes for poor investment performance have been published in recent years, many of which blame market unpredictability and volatility. Some of the reasons, are as plausible as a student whining to the instructor that “the dog ate my homework.” We should not blame our mistakes on so-called unforeseeable events, even if we have made them.
Hindsight bias, is a very dangerous state of mind since it obstructs your ability to learn from past mistakes by clouding your objectivity when evaluating past investing decisions. To avoid hindsight bias, we devote a large amount of time ahead to crafting the investment thesis for each stock, which includes our expected return. With the advantage of hindsight, this makes it more difficult to’rewrite’ our investment history. This is something we do for both individual stock investments and macroeconomic forecasts.
7. Bandwagon Effect (or Groupthink)
The bandwagon effect, also known as groupthink, illustrates how people become comfortable with something because many others do (or believe) the same thing. To be a good investor, you must be able to analyse and think independently. Speculative bubbles are frequently the outcome of herd mentality and groupthink. We take no solace or pride in the fact that others are doing the same things as us or that others agree with us. We shall be right or wrong at the end of the day because our analysis and judgement will be correct or incorrect. While we do not strive to be contrarians, we have no qualms with following ‘the route less travelled’ if our analysis suggests it.
8. Restraint Bias
The propensity to overestimate one’s ability to resist temptation is known as restraint bias. This is frequently linked to eating problems. The majority of people are programmed to be ‘greedy,’ wanting more of a good thing or a’sure winner.’ Money is the ultimate temptation for many individuals. Many investors struggle with how to properly size an investment when they believe they have found a “guaranteed winner.” Many investors, have gotten themselves into trouble by overindulging in their “greatest investment ideas.” ‘Sure thing’ investments, in our opinion, are extremely unusual, and many investments are subject to changes in assumptions, especially macroeconomic estimations & assumptions.
We hardwire restraints or risk controls into our method to overcome our natural urge to acquire more and more of our greatest ideas. These risk controls put maximum limits on stocks and combinations of equities that we deem to have aggregation risk. The usefulness of risk controls in reducing human avarice is nicely represented by Oscar Wilde’s quote: “I can withstand everything except temptation.”
9. Neglect of Probability
In making decisions, humans have a tendency to ignore, overestimate, or underestimate probability. When making financial decisions, most people are prone to oversimplifying and assuming a single point estimate. The reality is that an investor’s desired outcome is their best or most likely estimate. The distribution curve, which surrounds this outcome, is a distribution of probable outcomes. Depending on the nature and competitive power of a particular organisation, the shape of the distribution curve of probable valuation outcomes might vary substantially. Enterprises that are more mature, less affected by economic cycles, and have particularly strong competitive positions have a tighter distribution of valuation outcomes than businesses that are less mature, more affected by economic cycles, or more vulnerable to competitive forces.
Another common blunder made by investors is overestimating or mispricing the risk of low-probability events. That isn’t to say that ‘black swan’ occurrences don’t happen; but, overcompensating for extremely low-probability catastrophes can be costly to investors. We should try to reduce the risk of “black swan” events by incorporating a significant number of businesses (at appropriate prices) in the portfolio where we feel the distribution curve of valuation outcomes is very tight. These are what are called high-quality long-cycle businesses. In this component of the portfolio, we should feel the chance of a lasting capital loss from a “black swan” occurrence is minimal. We should not hesitate to make a major modification to the portfolio, particularly our holdings of shorter-cycle businesses, if we have solid insight that the possibility of a “black swan” occurrence is materially increasing and the pricing is favourable enough to mitigate this risk. For investors, the challenge is determining when the likelihood of such an event is considerably growing. It is rarely linked to the quantity of press or market publicity given to a certain event. “The biggest error you can make in equities is to buy or sell stocks based on current headlines,” Warren Buffett once observed.
10. Anchoring Bias
When making a decision, anchoring bias is the tendency to depend too heavily on, or anchor to, a previous reference or one piece of information. Many academic studies have been conducted on the impact of anchoring on decision-making.
The recent share price is a clear anchor from an investment standpoint. Many investors make selections based on the current share price in relation to its trading history. In reality, there is an investment school of thought known as technical analysis, that is based on the analysis of share prices. Unfortunately, a stock’s price has been in the past provides little indication of whether it is cheap or costly. We should make investing decisions based on whether the share price is trading at a discount to our estimate of intrinsic value, not on where the share price has been previously.
“If you are presenting people with information, be aware of what happens to human behavior when you don’t provide context. When you’re not giving people ample information. When you’re making people make decisions faster than they are capable of making it,” said George M. Blount, a financial therapist & founder of Balance Financial. “That is going to increase the likelihood that the response is not in their best interest. And that’s going to be a problem, not in the present day, but maybe in the future. And so you have to be aware of that. “
All in all investors suffer from various biases and they should not lose sight of these biases while making critical investment decisions.
We hope these Top 10 Investment Biases | Investment Biases that every Investor must avoid help you to plan a financially successful future. If you need any assistance on Investment or How To Invest In Mutual Funds Feel free to contact Wealth Baba – Financial Planner & Investment Advisor in India. We will try to help you out in the best possible way.