The investor’s chief problem and even his worst enemy is likely to be himself. – Ben Graham.
Let us look at some of the behavioral biases that drag down the investment returns.
First of, Why do we suffer these behavioral biases?
The answer lies in the fact that our brains have been refined by the process of evolution, just like any other feature of our existence. But the evolution occurs at a glacial pace, so our brains are well designed for the environment we faced 150,000 years ago (the African savannah) but potentially poorly suited for the industrial age of 300 years ago, and perhaps even more ill-suited for the information age in which we currently live.
1. X-system (emotion) vs. C (cognitive) -system (logic & reason) response
Simply it is Dr. McCoy vs. Mr. Spock for the Star Trek fans
Wish that it were so vs. evidence and logic will be required
Success in investing doesn’t correlate with IQ once you’re above the level of 100. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. – Warren Buffett.
2. Empathy Gaps
What would you do in the heat of the moment? We are not good emotional time travelers. Use the C-system to overcome this bias of making an investment decision in the heat of the moment, say by means of an auto execution, stop-loss or strict rules. Prepare, plan and pre-commit to a strategy (process) and avoid the perils of procrastination.
3. Self-attribution
It is our habit of attributing good outcomes to our skill as investors while blaming bad outcomes on something else
4. ADHD Investing
Investors today appear to have attention deficit hyperactivity disorder when it comes to their portfolio. At least be aware of it. Does good returns justify this? May be traders are exempt from this one.
5. Action Bias
Never under estimate the value of doing nothing. – Winnie-the-pooh
You could be right for the wrong reason (good luck)
You could be wrong for the right reason (bad luck)
You could be wrong for the wrong reason (mistake)
You could be right for the right reason (skill)
When dealing with losses, the urge to reach for an action bias is extremely high.
The antithesis of action bias is patience.
Science of Hitting by Ted Williams (0.344 career batting average)
wait for the fat pitch
I call investing the greatest business in the world … because you never have to swing. You stand at the plate, the pitcher throws you GM at $47! US Steel at $39! and nobody calls a strike on you. There is no penalty except opportunity lost. All day you wait for the pitch you like, then when the fielders are asleep, you step up and hit it.
– Warren Buffett’s quote from Science of Hitting
6. Confirmatory Bias
We look for ways to confirm our own position and are blind to opposing view points and hold our positions too long. We should look for opposing view points (kill the company) and overcome them by reason and logic (C-system)
7. Endowment Bias
We don’t want to give up easily something that we own. We can not over come the inertia until we are forced to do so.
8. Status quo Bias
Stay where we are in our comfort-zone.
9. Risk aversion
In golf the percent completion of ‘par’ is greater than that of a ‘birdie’ or ‘eagle.’ Dropping a shot is more riskier than missing a birdie or an eagle.
10. Risk loving (appetite)
The loss is not a loss until it is realized. Defined risk is not chosen, but a chance of a higher risk is chosen instead for a better return.
11. Disposition Effect
Holding on to losers longer and selling the winners too soon. Loss aversion. We gamble on the potential gain rather than accepting the potential loss. It is tied to risk appetite.
12. Hindsight bias
Monday morning quarter backing. Once we know the outcome we tend to think we knew it all the time. It is therefore a good idea to keep a journal of how the decision was made that lead us to the benefit and use this information in the future decision making process rather than using the assessed information after the fact which may not be the same.
13. Sunk cost bias
We defend our position where we have sunk our cost into.
14. Self-serving bias
Don’t ask the barber if you need a haircut.
All news is good news
Everything is always cheap
Assertion trumps evidence
15. Predictable surprises (not a Black Swan)
They comprise
over-optimism (cognitive system resistant bias and is the default system embedded in the x-system thinking)
illusion of control (just because we can define the risk it doesn’t become risk-free, result of hindsight bias)
self-serving bias
myopic (short-sighted overt focus on the short term) and
inattention blindness (we simply don’t expect to see what we are not looking for)
16. Narrative Fallacy
Just because everything flows into a neat narrative story, doesn’t mean it will produce the same success for someone imitating the story.
The fallacy is associated with our vulnerability to over-interpretation and our predilection for compact stories over raw truths. It severely distorts the mental representation of the world. – Taleb in Black Swan.
17. Capitalizing Hope
Hoping is not a strategy; not obvious with the benefit of hindsight bias. The market never failed to overpay for the long-term realized successes of the growth companies. Just use cold facts, no stories and a factor of safety.
18. Greater fool’s theory
An example is, one buys an over valued stock and expects some greater fool would buy the stock from him at even a great price, thus making a profit.
19. Listening to authority figures
Don’t question authority; they don’t know the answer either.
20. The folly of forecasting
It is like weatherman forecast. It is not reliable yet it provides some basis to do something. We simply don’t know. You can’t predict; you can prepare.
I would prefer to be approximately right rather than precisely wrong. – Keynes.
21. Information Overload
Too much information does not help. Confidence goes up but not accuracy with information going up. Distinguish the signal from the noise.
22. Mr. Market
He is a chronic manic depressive (bi-polar). Those who focus upon market price for investment advice are doomed to failure.
It is largely the fluctuations which throw up bargains and the uncertainty due to the fluctuations which prevents other people from taking advantage of them. – Keynes.
23. Spotting bubbles
Nowhere is an appreciation of stock market history more important than in understanding bubbles. Bubbles are a by-product of human behavior. They are not “Black Swans” because they can be predicted.
24. Lemmings Syndrome (to be avoided)
Be a contrarian Investor.
It is impossible to produce superior performance unless you do something different from the majority. – Sir John Templeton
25. Process not Outcome
We can only control the process and no outcome. Therefore do control the process. The road to hell is paved with good intentions. We all have good intentions in investing, but unless we religiously follow the process, it will not lead to heaven … but the other.
All these behavioral biases do exist in our day-to-day transactions in real life as well, if you look for them and be aware of them. So we have a bonus situation of applying the corrective actions in real life as well in addition to applying them in the investing world of ours.
Courtesy: The Little Book of Behavioral Investing by James Montier.