What are behavioural biases?

Investor biases can be categorized into two types, cognitive or emotional. These biases are irrational thoughts and feelings that affect our decision-making, whether subconsciously or consciously. An investor can have one or multiple biases that lead to misjudgments. Recognising our behaviours and biases is essential to becoming a better investor, but we cannot wholly eliminate them. Instead, we can identify them and put measures in place to overcome them.

TABLE OF CONTENTS: Investor Biases

Investing has many pitfalls that can lead to a lot of investor biases at work at the same time. These investor biases can prevent an investor from making rational decisions by creating an unrealistic perception of the markets and how to navigate them.

The primary difference between traditional economics and behavioural economics is the role of psychology and investor biases in decision-making. Investor Biases cause us to act based on our emotions rather than sound logic. Emotions play a significant role in wealth and money decisions, and a range of emotions can affect our judgments.

From time to time, we all have errors in our thinking that distort the way we process information or choose to ignore it.

Confirmation bias

Confirmation bias is a common issue among investors. Many investors tend to search for information that supports their existing beliefs and ideas and ignore any evidence that contradicts them. This can lead to overconfidence and a failure to consider important information that could affect their decisions. It’s also common to rely too heavily on certain investors who have been successful in the past.

To combat confirmation bias, it’s important to actively seek out opposing views and evidence that contradicts your own ideas. It’s important to be humble enough to change your mind if the facts change. It’s also helps to test your ideas by evaluating all available information and not relying solely on your own judgment and research.

Confirmation bias can be a problem in many areas of life, including politics, religion, and even food preferences. If we only seek out information that confirms our existing beliefs, we run the risk of making poor decisions and missing out on important relevant information.

For example, if you are a value investor, it’s important to remain open to other methods and not rely solely on your existing beliefs. It’s important to listen, learn, watch, and look out for value while also considering other perspectives and approaches.

Loss aversion

Loss aversion is a behavioural bias that causes us to feel the pain of a loss more intensely than the pleasure of gains. This can lead to irrational investing decisions, such as holding onto poor-performing investments longer to avoid the pain of locking in the loss. We may hope for a turnaround or that the investment will recover, but this can be detrimental to our portfolio. On the other hand, loss aversion can also make us sell winning companies prematurely to book profits, missing out on potential gains.

For example, if we were to book $10,000 in profits on an investment, we would feel good. However, if we lost $10,000, we’d feel discouraged, down, annoyed, and anxious. Loss aversion can cause us to be overly conservative in our investment strategies, leading to missed opportunities and suboptimal portfolio management. To combat this bias, it’s important to stick to a long-term investment strategy. When loss aversion kicks in, investors may sell the stocks that are going up to cover the shortfall of the stocks going down, instead of letting their winnings keep growing.

Anchoring effect

Anchoring is a common bias that affects investors. It occurs when they pay a particular price for a stock and then rely on that price as a benchmark for its value. Even if the company’s fundamentals change and the actual intrinsic value becomes lower, investors may dispute the new information and continue to anchor to the original price they paid.

Anchoring can also cause investors to ignore a company’s future growth potential because they are fixated on the current share price. This can lead to a situation where investors rely solely on the first piece of information they receive when evaluating investment opportunities, even if the market conditions or information change.

Price anchors can be dangerous, as they can cause investors to overestimate the value of a stock and create a fictitious base of value in their minds. It is important to be aware of this bias when making investment decisions to avoid making mistakes due to anchoring.

Information bias

As we discussed in our previous article about Ignoring the Noise, the vast Investment Universe can create a bias known as Information Bias. This bias refers to the tendency to evaluate, research, and use information that is actually useless for achieving our goals. To make informed decisions and think logically, we need to carefully filter out irrelevant information and focus on what is essential.

Often, we seek out and use information that is not necessary and can over-analyse, finding too much information and creating an information overload. To counteract this bias, we need to question the source of the information, understand where it comes from, who is behind it, and how it can be applied to our goals. Investors are bombarded with information from various sources, such as social media, financial media, news, and investment websites. Too much information can overload our minds and blur our views on what is relevant and what is not.

Many investors make financial decisions based on irrelevant information. To avoid this, we need to ask ourselves if the information we are researching will help us assess what we need. If not, we should discard it. Even when researching companies and analysing ideas, having a strict information process is vital. Otherwise, we may read hundreds of articles and forums instead of a few annual reports to find key information.

Herding Bias

Herd Mentality is a phenomenon that contributes to market hysteria, booms, busts and the overall Market Cycle. Herding refers to the way investors follow the crowd and make investment decisions. Instead of making independent decisions, they base their strategy on the actions of others, which often causes bubbles or ridiculous market movements.

Independence is rare in investing, as most investors are influenced by what others are doing and driven by emotions like the fear of missing out. We tend to surrender independent analysis and outsource our thinking to the herd.

Investor herding is very common because it is easier to imitate another investor or a group without doing the research. If it seems that a lot of investors are piling into a stock, a certain asset class or a thematic theme, people tend to follow suit. However, following the herd can be risky. The whole investment universe is made up of herds, all in different classes, segments of the market, and different investment styles.

Hindsight bias

Hindsight Bias is a phenomenon in which investors tend to convince themselves that they predicted an event before it happened, such as a market cycle transition or a company’s soaring or collapsing. However, this bias becomes dangerous when the knowledge acquired after an event influences the ability to predict future events. Moreover, people tend to perceive past events as being more predictable than they were at the time.

In the case of financial crashes, such as the Global Financial Crisis, people tend to be confident in their ability to predict such events after they have occurred. However, it is important to note that if people truly knew about the event, they would have taken preventive measures, such as backing up the trucks and shorting it.

Familiarity bias

Investors tend to rely on familiar information and focus on areas they already know about, which is called familiarity bias. This is different from staying within your Circle of Competence, which involves investing in areas you have knowledge and expertise in. Familiarity bias can limit investors and prevent them from exploring new markets and diversifying their portfolio.

Investors with familiarity bias often rely on information from sources they are already familiar with, rather than seeking out new and diverse sources. This can lead to a lack of independent thinking and limit an investor’s potential growth. To become a successful investor, it’s important to constantly learn and expand your knowledge about different markets, industries, companies, and themes. Many investors tend to focus on a specific segment of the market, such as blue-chip companies, and limit their exposure to other areas.

Overconfidence bias

Overconfidence bias can be a real killer. It’s something we’ve all experienced at some point on our journey. When the market is bullish, we can become arrogant and think we’re brilliant. This bias is the tendency to overestimate our abilities and knowledge, leading to poor decision making.

Overconfidence can cause excessive trading, shortcuts in research, under-diversification, and taking on excessive risk. When we trust our abilities too much, we neglect the necessary checks and balances. Without conducting due diligence and having a strategy or process in place, investors can easily fall prey to overconfidence. Traders who experience a few wins in a row and become too confident often end up losing.

When we pick a small-cap stock that booms, it’s easy to think we’re magic. But neglecting research on the next stock due to our inflated ego can lead to mistakes. Staying humble, reflecting on losses, and following a sound process while staying disciplined to our philosophy are our own protections against overconfidence.

Sunk Cost Bias

The Sunk Cost Bias is a common behavioural trap that many people, including myself, have experienced. It refers to the tendency to continue with an action we have already invested money, time and effort, even if the current costs outweigh the potential benefits.

For instance, we may have invested in a company that we poured a lot of time, energy, and capital into. When the company fails, we fail to adapt to the new evidence that it was a poor investment. We hold onto it and may even invest more money averaging down, refusing to accept that the sunk cost bias has taken hold of us.

This can also apply to our investment strategies or goals. We may have spent a significant amount of time studying a particular market segment or investment style. However, we fail to adapt to changing evidence or do not get the desired results. We persist in our approach because we have already invested so much time and energy into it.

The best way to overcome this bias is to acknowledge it when it occurs and cut your losses. Change course and move on. Often, persisting in a losing investment will only lead to further losses.

Recency bias

Recency Bias is a common phenomenon in the world of investing. It occurs when investors and analysts make decisions based solely on recent events, data, and trends, assuming that they will continue into the future. This often leads investors to overemphasize recent events and overlook long-term historical data.

Investors tend to invest heavily in the best-performing funds of the previous year, expecting them to perform well in the current year. Analysts base their projections on past data and momentum, assuming that market cycles will continue to follow the same trends. This prioritization of recent knowledge over long-term historical data is known as Recency Bias. It involves taking current and past information as though it is bound to happen in the future.

It is essential to always look deeper into independent research and analysis regardless of past and current data trends. Last year’s best-performing class, fund, company, or theme may not necessarily be the best for next year. Recency Bias can even affect our research ability by limiting us to companies that have most recently come to our attention.

We can never neglect sound fundamentals and must always consider long-term historical data when making investment decisions.

Survivorship bias

Survivorship bias refers to the tendency of focusing on the survivors, whether it is a fund, portfolio, segment of the market, or other areas. For instance, we often concentrate on a strong performing fund without considering all the poor performing funds that are closed. Similarly, we see a handful of small-cap stocks performing well in perhaps online retail, but ignore the hundreds that have gone bankrupt.

This approach of concentrating on what is alive and well can create very optimistic and distorted views. Investors frequently overlook the failures, and companies are excluded from data points and analysis of performance.

Survivorship bias is most prominent in the fund industry, where excluding funds and companies that cease to exist creates a much more optimistic outlook. This practice of washing out negativity, underperformance, and packaging up the survivors is common.

If you are working on an industry, a certain theme, or a particular investment, instead of analysing against the survivors in the market, invert the idea, find out why the other companies that didn’t survive failed. It can help you to avoid distorting your analysis.

Gambler fallacy bias

The Gambler’s Fallacy is a phenomenon where an investor or trader assumes that a random event is more or less likely to happen based on the outcome of a previous event. This happens because humans tend to avoid accepting randomness in life, especially in financial markets. Often, investors look for patterns or price trends and make investment decisions based on the assumption of where the market is heading. However, they tend to overestimate the probability of an event mainly because it has not occurred recently.

For instance, a gambler at a casino may believe that red is more likely to come up on the roulette table because black has come up ten times, only for black to come up 17 more times. Similarly, investors may make decisions based on the belief that the market has to go up because it has been down for a long time and is bound to make a correction.

During my early days of investing, I encountered this bias many times in forums. Watching the often exciting but more often unprofitable practice playout. “Investors” looking for trends and patterns that didn’t exist and, even worse, risking real capital in the process.

To avoid this bias, it is essential to practice sound fundamental discipline and adopt a pragmatic approach to investing.

Endowment effect

The Endowment Effect is a phenomenon where people tend to value investments they own more than investments they don’t own. This can lead to investors holding onto their stocks or only looking to sell them at prices higher than their actual worth. This is known as anchoring to the price that they have paid. People can be willing to sell at higher prices or buy at lower prices even if the value is the same. This attachment to stocks, companies, brands and stories often goes beyond the value of the holdings.

Once the Endowment Effect takes hold, investors tend to ignore the fair market value or intrinsic value of the business and value their position as greater than its actual value. It is also referred to as the “ownership effect”. Since it is in our possession, we tend to value it more than what other investors may hold, even though there might be better opportunities available.

I believe this effect is often due to investors not knowing the value or how to value a business. A lot of the time, no thesis, research or strategy is in play. Having a thesis with buy and sell clauses and an idea of the value can help overcome this effect, as it is all about the underlying business, its potential in the future, and what is the fair value for that.

If a thesis doesn’t play out, it’s important to sell instead of holding onto losing ideas. I’ve seen investors hold onto companies even during big sell-offs, and then go on to make big returns. They were not anchoring, nor was the endowment effect at play. They had sound research and analysis, and the thesis was still being played out.

Framing

The framing bias is a phenomenon in which investors perceive information presented to them in a positive or negative light. This can occur through options, investment ideas, and reporting, all of which can frame the same situation in different ways. Typically, investors tend to view positive information more favourably than negative information.

As a result, investors may make decisions based on how information is framed, rather than on the underlying facts. This is particularly true in the investment world, where buy-side recommendations far outweigh sell-side recommendations. Positive news broadcasts, major gainers, positive earnings releases, and pretty annual reports can all frame subpar results as amazing.

To make informed decisions, investors need to sift through the information and examine the underlying evidence, rather than relying solely on how the information is presented to them. For example, consider a company that reports a decline of 2% in revenue from the previous quarter. Investors may perceive this as negative and respond accordingly. However, if the same information is presented positively, such as “Revenue has risen 10% this quarter compared to the same quarter last year,” investors may view the situation more favourably, despite the different time periods being compared.

Ultimately, it is important for investors to make decisions based on the facts, rather than how information is presented to them. By doing so, investors can avoid the pitfalls of framing bias and make more informed investment decisions.

Self-Attribution

Self-attribution bias is a common tendency among investors, where they attribute successful decisions and outcomes to their own actions but blame external factors for negative outcomes. This bias is often combined with overconfidence and ego, leading investors to inflate their capabilities. When an investment thesis plays out and the investor books a profit, they tend to pat themselves on the back, attributing the success to their solid research and great work. However, if the outcome is bad, they are quick to blame market conditions, poor industry or bad management, instead of accepting that they may have made an error.

This tendency to protect one’s ego from being wrong can lead to overconfidence and multiple biases working against investors. It can also lead to a reversal of roles, where investors credit themselves for the success of a company or segment, such as small-caps, during a bull market. However, it is often just the nature of the cycle that is responsible for the favourable outcome.

Investors should be wary of becoming overconfident during bull markets and avoid self-attribution bias. It is important to stick to logical and sound fundamental practices, even during favourable market conditions. Blaming external factors for negative outcomes and taking credit for positive ones can lead to poor investment decisions and wipe out an investor’s portfolio during a bear market.

Summarising Investor Biases…

Investor biases can significantly impact investment decisions, leading to poor outcomes. Being aware of these biases and taking measures to counteract them can help in making informed investment decisions. Even though we might be aware of these biases, they can still creep in subconsciously, leading us to ignore logic and facts.

Therefore, it is essential to have a short list of biases and reflect on them regularly to avoid falling prey to them. It is also essential to learn from one’s mistakes and those of others, stay humble, and acknowledge that losses happen to everyone.

Charlie Munger once said that investing and wealth creation are sometimes about avoiding stupid mistakes. These biases can lead to such mistakes, which can be avoided by practicing sound judgment and maintaining a clear frame of mind. Therefore, it is essential to be vigilant about the biases and overcome them to make sound investment decisions.