"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one."― Charles MacKay, "Extraordinary Popular Delusions and the Madness of Crowds."
"The investor's chief problem—and even his worst enemy—is likely to be himself." – Benjamin Graham.
Cognitive and emotional biases can trap investors because they affect one's ability to gather evidence, interpret evidence, take action and evaluate their decisions. Here are some biases that commonly occur in investing.
Confirmation bias involves selectively gathering and interpreting evidence to conform with one's beliefs, as well as neglecting evidence that contradicts them. An example is refusing to consider or to discount alternative views once an initial thesis has been established, even though data might contradict it.
This bias leads investors to see what they want to see rather than reality. Most bad investment ideas starts out as a good idea, but ideas, like wine, have a "good before" date. If we store a bottle of wine too long, it begins to deteriorate. John F. Kennedy said, "Too often we enjoy the comfort of opinion without the discomfort of thought." Since this occurs early in the investment's trajectory, confirmation bias can lead us to accept stories being passed on to and accepted by other investors without critically questioning their validity, a process which manifests itself as momentum, and momentum almost always overshoots.
We see this happening with Tesla Inc. (NASDAQ:TSLA), where a group of early and astute investors recognized the electric vehicle manufacturer was a disruptive company led by a charismatic CEO. However, investors later looked at the upward momentum of the price risk, becoming overcome by fear of missing out and used the upward price action as the primary justification for jumping on the bandwagon. They were seduced by stories of disruptive technologies, network effect, first-mover advantage, fantastic leadership and the vast total addressable market and discounting things like competition, inertia, infrastructure, range anxiety and energy density. Whether these stories will prove right or not down the road, or at what time line it will be right or wrong, is unknown, but the fact is investors respond much better to stories rather than just numbers.
Confirmation bias can lead to overconfidence and the tendency for people to believe that they are better or more educated on a topic than they really are. This is also known as illusory superiority in clinical psychology. However, it is better known as the Lake Wobegon Effect. This name comes from the radio variety show "A Prairie Home Companion," which is set in a fictional town in Minnesota called Lake Wobegon, where, "all the men are strong, all the women are good looking, and all the children are above average." A closely related bias is the Dunning-Kruger effect, where incompetent or unskilled people fail to recognize their own incompetency.
This bias can occur both when the price is moving up or when it is moving down. Investors need to be alert of such situations and the threats and opportunities it represents for their own portfolios.
A way to counteract confirmaton bias in our own decision-making is to continually challenge the status quo, as Charlie Munger (Trades, Portfolio) said: "Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side."
Munger frequently quotes Carl Jacobi, the famous 19th century mathematician: "Invert, always invert."
The hot hand and gambler's fallacies
The hot hand fallacy and gambler's fallacy are derivatives of the confirmation bias. The hot hand fallacy occurs when an individual (erroneously) assumes that recent past results are a good predictor of future outcomes, when in reality the events are independent of each other. Investors are susceptible to the hot hand fallacy, and they will commit more funds with the expectation of a continuous positive performance record in the short to medium term.
The gambler's fallacy is the erroneous belief that if a string of events occurred more recently in the past, it is less likely to happen in the near future. The gambler is unconsciously assuming that having sustained a string of losses, he is owed a win for some reason or another.
One has to be careful, therefore, since both fallacies assume the subject events are random and independent of each other. However, we know that in the long run stock markets are biased to increase (e.g., the long-term return of the stock market, as measured by the S&P 500 Index from 1957 to 2018, is about 7.96%).
Momentum is also a real factor in stock investing as it is very much dependent on animal spirits, which are not quantifiable. A big part of investing is separating the wheat from the chaff. It's safe to say Warren Buffett (Trades, Portfolio) is the genuine article and a bona fide genius, given his long track record. Can we say the same about Cathy Woods? It is possible that her ARK Innovation (ARKK) exchange-traded fund is a product of hot hand Fallacy or is she the Michael Jordan of the investing world? It's hard to say since we don't have enough data.
Anchoring bias is similar to confirmation bias and refers to the practice of prioritizing information and data that support one's initial impressions of evidence, even when those impressions are incorrect. It is rooted in a psychological self-defense mechanism called "cognitive dissonance," the tendency to dismiss disconfirming evidence. This is particularly so when one has invested heavily in a point of view, either materially or emotionally. Belief is when someone else does the thinking and it is true that believing is less work than thinking. It takes a lot of effort and emotional energy to change one's mind and most people are unwilling to cast off the "anchor" of their belief.
Imagine an investor who bought into GameStop Corp. (NYSE:GME) at $200 early in 2021, watched the stock shoot up to $300 and is still holding on because he is loath to take a loss. Or the lucky investor who bought it at $3 in 2019 and watched the stock shoot up 100 times. Did he sell at the top or is he still holding out for more?
Of course, the reverse is also true, the investor who bought at $3 and sold out at $6 and then watched the stock go to $300. Its never easy. The thing to remember is the stock does not care what you bought it for, what matters to the share price are factors which are essentially out of your control. The only things an individual investor controls is buy, sell or hold decisions and his awareness of cognitive traps.
Anchoring bias is rooted in loss aversion, which refers to the tendency to dislike losses more than we like to experience a gain. Simply put, people would rather not lose $1,000 than gain $1,000. When investing during a bear market, the sting of a recent loss prevents an investor from taking on the level of volatility required to ensure portfolio growth over the long term. The loss-aversion tendency breaks one of the cardinal rules of economics; the measurement of opportunity cost. To be a successful investor over time you must be able to properly measure opportunity cost and not be anchored to past investment decisions due to the inbuilt human tendency to avoid losses. Investors who become anchored due to loss aversion will pass on superior investment opportunities to retain an existing loss-making investment in the hope of recouping their losses.
Anchoring bias can cause problems in a long recession when investors badly mauled by a grinding bear market assume a fetal position, when, in fact, they should be aggressively taking advantage of low prices. This is best illustrated by a quote by the English economist A.C. Pigou, who wrote in "Industrial Fluctuations" in 1927, "Prosperity ends in a crisis. The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born, not an infant, but a giant."
Closely related to loss aversion is the endowment effect, which occurs when people place a higher value on a good they own than on an identical good they do not own. Rationally, all past decisions are sunk costs and the tendency to hold on to investments must be continually measured against missed opportunity costs. Warren Buffett gives the illustration that investors would achieve superior investment results over the long term if they had an imaginary punch card with space for only 20 holes. Every time they made an investment during their lifetime, they had to punch the card. In Buffett's view, this would force investors to think carefully about the investment, including the risks, which would lead to more informed investment decisions. Of course, to do this, you should know what you are doing and a amateur investor is better off holding a broad index fund. Buffett demonstrated his mastery of the sunk cost and opportunity cost concepts when he dumped his large holding of International Business Machines Corp. (NYSE:IBM) and bought Apple Inc. (NASDAQ:AAPL) a few years ago. He did that as soon as he came to the conclusion that IBM was a mistake and Apple was a better investment. He was proven resoundingly right in the following years.
Recency bias is related to anchoring bias and confirmation bias as investors pay more attention to what has happened recently versus in the more distant past. As French fashion designer and businesswoman Coco Chanel said, "Nothing is new, it is just forgotten.".
This bias raises its head in bull markets like we are currently experiencing or during prolonged bear markets like those in the 1970s and '80s. Investors tend to get overexcited or despondent based on recent experiences. A contrarian investor can take advantage of this bias by going against the grain. Investors should remember that markets have a tendency in the long term to return to trends and stocks to revert to the mean. That is why astute investors like Buffett and Seth Klarman raise large amounts of cash when times are good, so they can swoop in and take highly undervalued securities that panicked investors are selling during bear markets.
We all tend to gravitate toward the familiar and fear the unknown. This tends to give rise to the familiarity bias. Despite obvious gains from diversification, (the only free lunch in investing) investors prefer "familiar" investments of their own country, region, state or employers. It is good practice to not only diversify across geographies, but also different factors and styles such as value and growth, large cap and small cap as well as asset classes. In areas where the investors do not feel competent, using mutual funds or ETFs is a good strategy.
Affect heuristic describes when an investor's actions are swayed by emotional reactions. For example, emotional reactions caused by sudden price movements instead of rational deliberation about risks and benefits. It is context or investment-specific and can manifest when investors experience positive or negative feelings toward an investment or the market based on prior experiences.
An example of this is what happened on Feb. 19, 2020, when investors suddenly woke up to the threat presented by the Covid-19 pandemic to the U.S. stock market, became incredibly fearful and began to sell indiscriminately. Selling begat more selling, even though rational thought would indicate that pandemics are temporary and normality will eventually return. Sense began to return to the stock market participants on March 23, 2020, when the current bull market began. Affect heuristic affects investors both when prices are crashing as well as when they are melting up. The fear of missing out is a symptom of the latter.
It is much more acute on the way down rather than the way up as fear is a much stronger emotion than greed. When you are in throes of despair — experiencing intense feelings of suffering and agitation, it's a good time to remember one of Buffett's classic rules: "Be fearful when others are greedy, and be greedy when others are fearful". Though overcoming fear is easier said than done, there is no comparison between fear and greed. Fear is instant, pervasive and intense. Fear hits you in solar plexus. Greed is slower burn.
Mental accounting error
Mental accounting error refers to separating money into various subjective buckets. Think of an employment bonus earned in addition to a regular salary. If someone earns $5,000 per month, they are more likely to use that money in a disciplined manner to pay down debt, invest, etc. However, if that same person were to receive a $15,000 bonus, they are more likely to spend it with less thoughtful intention.
The money is regarded differently in these two instances, when, in reality, it's still money that should be used in a thoughtful manner. This is why it's important to consider the entire financial situation as a whole and assess the impact each financial decision has on a long-term plan. This is true in investing as well, as many investors are only interested in dividends and think them like a paycheck and capital gains as a lottery.
For instance, they would rather invest in a highly leveraged finance company because it pays a double-digit dividend than in Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), which has a strong balance sheet and has appreciated at double digits for the last 30 years. In reality, money is money and is fungible, so its perfectly fine to sell some of the appreciated stock to generate income rather than invest in the dodgy finance company just to get a dividend. Another common mental accounting error is to maintain a large credit card balance while still holding substantial cash in a checking account.
Mental accounting is also related to loss-aversion. For instance, an investor owns two stocks: one with a paper gain, the other with a paper loss. The investor needs to raise cash and must sell one of the stocks. Mental accounting is biased toward selling the winner even though selling the loser is usually the rational decision due to tax loss benefits as well as the fact that the losing stock is a weaker investment. The pain of realizing a loss is too much for the investor to bear, so he sells the winner to avoid that pain. This is a mental accounting error and the loss-aversion effect that can lead investors astray with their decisions.
Information bias comes into play when investors evaluate information even when it is not useful in understanding a problem or issue, or ignoring information which is important but is too complex to understand. Both over-thinking and under-thinking can be bad for the investment process.
The key to investing is to see the forest for the trees and weigh information that is relevant to making a more informed investment decision and ignore the noise. Investors are bombarded with information every day, from financial commentators, analyses, news sources and institutions, so it is difficult to filter through it to focus on information that is relevant. In many instances, investors will make investment decisions to buy or sell an investment on the basis of short-term movements in the share price. This can cause investors to sell wonderful investments if the share price has fallen and to buy into bad investments on the basis that the share price has risen. The opposite can happen as well when investors hold on to losing investments and take profits on long-term compounders based on transient setbacks.
In general, investors would make superior investment decisions if they ignored daily price movements and focused on the medium and long-term value for the underlying investment and looked at the price in comparison to intrinsic value. By ignoring daily commentary regarding share prices, investors would overcome a dangerous source of information bias in the investment decision-making process.
As Albert Einstein said, "Make things as simple as possible, but no more simple." That is laudable goal. However, in seeking to understand complex matters, we humans tend to want simple explanations. Unfortunately, some matters are inherently complex or uncertain and do not lend themselves to simple explanations.
In fact, some matters are so uncertain that it is not possible to see the future with any clarity. We can fall into the simplicity trap when we seek simple answers to complex problems. A key to successful investing is to stay within your circle of competence. A key part of that circle of competence is to concentrate investments in areas that exhibit a high degree of predictability and to be wary of areas that are highly complex or highly uncertain. As an example, forecasting the volume growth for predictable businesses like railroads and consumer staples is relatively foreseeable over the next five years. Investing in pharmaceuticals and biotech is far more complex, so we should not overly simplify the inherent complexity of a large drug company.
If we cannot grasp the complexity and uncertainty of a drug development project or be able value a patent and the competitive landscape, its better not invest, no matter how compelling the simplified investment case may appear. It may be better to invest in the areas outside our circle of competence via an index, ETF or mutual fund.
Outcome bias refers to the practice of believing that investment results—good or bad—are always attributable to their prior decisions even if the investor has no valid reason to think this, preventing him from assimilating feedback to improve his performance.
Although the relation between decisions and outcomes might seem intuitive, the outcome of a decision cannot be the sole determinant of its quality; that is, sometimes a good outcome can happen despite a poor decision, and vice versa.
Self-attribution occurs when investors attribute successful outcomes to their own actions and bad outcomes to external factors. This is a psychological means of self-protection or self-enhancement. Investors with self-attribution bias may become overconfident, which can lead to underperformance. To mitigate these effects, investors should track personal mistakes and successes and develop an honest and objective accountability process.
Luck is a very big factor in investing. Investors should remember not to confuse a bull market with brains and fall in love with their own genius. The reverse is also true. Just because something bad happened to your investment or you missed a big gain because you sold just before a big move does not mean you should quit the investment game. Like in the movie "Forrest Gump," the lead character played by Tom Hanks said, "My mama always said life is like a box of chocolates. You never know what you're gonna get."
Many of the cognitive and emotional biases described above are interrelated and act on investors simultaneously, forcing them into errors of judgement. To complicate matters further, many of the biases act at cross purposes and some of the biases may be right at certain time and wrong at another time.
Successful investing is not only making the right call, but anticipating the anticipations of others, while dodging the slings and arrows of Lady Luck. Its all about putting probabilities in your favor not black and white thinking. We have to make decisions in a world full of uncertainty and incomplete information, striving to be rational within the bounds of reality. We should remember as investors that we cannot control much beyond our buy, sell or hold decisions. Many investments need time to work out and many will be wrong in hindsight. Losses and errors need to factored in as we can't win everything. Hopefully by the end of our investing journey, we will have a lot more wins than losses.
As Charlie Munger has said about investing, "It's not supposed to be easy. Anyone who finds it easy is stupid."