Written by David Walker
Originally published by StocksInValue on 11 September 2015
Equity market participants make decisions for many reasons other than a rigorous assessment of corporate value. Often these reasons derive from decision making biases which are part of the human condition and our evolutionary inheritance. Behavioural finance is the combination of behavioural and cognitive psychological theory with conventional economics and finance to explain why people make these irrational financial decisions.
Many investors are becoming more aware of the observations and conclusions in behavioural finance and are using them to become more disciplined and less driven by biases which reduce investment returns. Value investors in particular must master their emotions as the practice frequently requires doing the opposite of not only the crowd of market participants moving share prices but also what our human instincts tell us to do. This is at least as important as valuation and stockpicking as good work here is easily undone by irrational decisions unrelated to risk and return.
The opportunities for value investors who minimise their behavioural biases are excellent. Hundreds of years after the invention of the sharemarket, markets continue to be driven by the revolving emotions of fear, greed, not wanting to lose money and not wanting to miss out. Predictable emotions are present at each stage of the market cycle.
Let us now examine five of the most common behavioural biases in investing and how you can increase your returns by avoiding them.
Anchoring bias: When we fixate on irrelevant prices
Many investors base their decisions on irrelevant figures, statistics and reference points. For example, it can be tempting to buy stocks which have fallen considerably over a short period. Here the investor ‘anchors’ to a recent share price because it is higher than the current price, and thus believes the price fall is an opportunity to buy a stock at a discount.
This is a dicey situation for value investors, who look for stocks available at a discount. While the market’s volatility does create undervalued opportunities, stocks also often decline in intrinsic value due to deteriorating fundamentals. Simultaneously not knowing when this is the case and anchoring to a previous ‘high’ share price risks buying a stock which keeps falling.
Rigorous critical thinking is essential to avoid anchoring bias. Be especially careful about which reference points you use to evaluate a stock’s potential. Successful investors evaluate a company against multiple benchmarks. If a growing number of these give a green light, you probably have a worthwhile investment.
Mental accounting: When we have different feelings about different investments
This is the tendency to put investments into separate ‘accounts’ based on subjective criteria like the source of the investments and intent for each account. This can reduce total returns. The temptation is to treat different shareholdings differently for emotional reasons like sentimentally hanging onto inherited shares, retaining a failed investment out of hope while sensibly managing the rest of the portfolio, hanging onto windfall gains even if the stock is way overvalued, and dividing a portfolio between quality and speculative to prevent negative returns on the specs from affecting the entire portfolio.
The fallacy here is to miss the reality money is fungible. Regardless of its origins, source or use all money is the same. Regardless of an investment’s history it has the same effect on total portfolio returns and should be managed in the same way as other investments.
Confirmation bias: Seeing what we want to see
We are all prone to preconceived opinions, or prejudices (positive and negative). First impressions can be particularly hard to overlook because people tend to selectively filter and pay more attention to information that supports their opinions, while ignoring or rationalising the rest.
Investors with a confirmation bias seek information which supports their original view of an investment rather than contradicting it. This bias can result in faulty decisions because one-sided information skews an investor’s perspective, leaving them with incomplete understanding. Common examples are not wanting to be wrong about an investment, pride and hubris in place of accepting an investment has gone wrong, a desire to defend an investment to others, believing someone’s investment advice or stock tips just because they are famous or charismatic, and letting a desire to make money leave one wanting to believe an investment will work.
What can happen is the investor seeks and finds positives about a company’s recent performance, like strong sales growth or a low debt to equity ratio while ignoring threats like technological disruption or the arrival of competitors with deep pockets.
Confirmation bias is the tendency to focus on information which confirms a pre-existing thought. To overcome it, find someone to act as a dissenting voice of reason or develop the ability to consider all sides of an argument yourself. This way you’ll be confronted with a contrary viewpoint to examine. The best advice here is to follow the dictum of Berkshire Hathaway luminary Charlie Munger to “always, always invert”, explored in his famous Almanack, which means to turn your own argument upside down and see if it can be defeated. If on the balance of probabilities it can’t, you probably have a good decision.
Loss aversion bias: When the pain of crystallising a loss is unbearable
This mistake is a classic and all investors have made it. It can be so painful to sell a stock at a loss, especially if this is taken as a blow to one’s pride or self-confidence, that many investors would rather not sell the stock and instead hold on in a vain hope of making the lost money back. Typically the failed investment is held until the pain of holding onto it exceeds the pain of crystallising the loss.
Loss aversion is a kind of mental accounting. Whereas money invested is fungible and the only question is where to find the highest-returning investments for an acceptable risk, loss aversion bias results in segregating bad calls because they are bad. The breakthrough is to appreciate the first cut is the best cut. If something happens to disprove your thesis for owning a stock and there is permanent loss of capital, it usually pays to sell early and move on, using the capital for better purposes.
Overconfidence bias: It’s natural to want to feel confident
This one exists because we all want to feel good, and we all feel better when we feel confident. Eons of sales training have taught salespeople how to steer their customers to feeling better about themselves and more confident about making decisions – the decision to buy, that is.
Direct equity investing, as an exercise in confronting and managing risk, tends to attract confident types less afraid of risk than the average person. This is good up to the point beyond which overconfidence reduces returns, usually by encouraging excessive trading. Very confident investors generally make substantially more trades than their less-confident counterparts, as they believe they are better than others at choosing the best stocks and best times to enter/exit a position. But a high volume of trading can reduce returns by increasing transaction costs, not allowing enough time for share prices to converge to intrinsic value, and not allowing enough time for the compounding of earnings to drive value growth.
Some of the best sage advice here is from the Oracle of Omaha. Warren Buffett once famously said every investor should act as if they have a punch card with 10 perforations on it and these should symbolise the 10 best investments, and the 10 only investments, the investor will make over an investing lifetime. Now maybe this advice is not quite practical but you get the concept. Avoiding overactivity and buying only what stacks up on multiple criteria can only help improve returns.
Many studies and surveys have found most investors from small investors to professional fund managers believe they are better than average. But clearly only 50% of a group can be above average, indicating these investors’ overconfidence.
Confidence is essential for success at investing but there’s a fine line between confidence and overconfidence. Confidence implies realistically trusting in one’s abilities, while overconfidence usually implies an overly optimistic assessment of one’s knowledge or control over a situation.
The best fund managers know every investment day brings new challenges, new patterns of volatility, new information – and the need for constant refinement of investment techniques. Confidence is preferred but humility is required. Wherever you invest, whether in a fund manager managing $50bn or a home office managing your retirement, our advice is to check your ego at the door.