When it comes to investing, often we can be our own worst enemy
Humans have evolved to make decisions in certain ways. Our brains have finite processing power so we use mental ‘shortcuts’ to make a lot of our decisions day to day. This method of decision-making has helped ensure our survival over thousands of years through droughts, famines and other dangers.
These shortcuts can help us to reach correct conclusions quickly, but when it comes to investing they can lead us astray — and we’re not even likely to realise it’s happening.
Here are five ways that our minds can affect our investing habits. Recognising and understanding these biases can help protect us from ourselves.
We’re all attracted to new high-performance numbers when we come across them. Recency bias makes it easy for us to recall and prioritise something that happened recently over something that happened further back in the past.
It’s easy to get excited by a small cap gold mine that your neighbour says returned 20% last month, or an emerging lithium stock that is all over the news. Strong recent performance can be too alluring to ignore, but we don’t easily recall all the small cap stocks that have failed over the years (and there are a lot).
On the flip-side, a recent downturn can loom large in your mind when you’re considering whether to make a new investment, and you might feel more cautious than usual because it’s easier to remember the sensational headlines than the good returns that preceded them.
After we identify an investment we like (whether it’s a speculative share or a property) we look for information that supports our opinion, and we discount anything that differs from that. Confirmation bias is very hard to side-step — it’s like a brick wall that won’t let certain information past unless we recognise the bias.
A good fund manager will actually seek out information that challenges their opinion to try to mitigate this bias, and a good investor should do the same thing. To compound this, investors may project a very narrow set of likely future outcomes as a result of their overconfidence in the decision they have made.
When we invest, we get anchored to a price that means a lot to us, but absolutely nothing to the broader market. Anchoring bias urges us to hold onto our losers in the hope their value will return to the original price we paid. The disposition effect describes how investors often sell stock winners too soon and hold onto losers too long. Conversely, if a stock falls from a recent high we may not want to sell because we’re anchored to the high-water mark.
When I was playing AFL, the feeling of losing a grand final had a much greater effect on me than the feeling I had when I won an AFL grand final. This is because the fear of losing something is twice as powerful as the desire to gain something. We need to be aware of this, as our instincts may be to sell investments once we see a headline predicting a potential correction or crash in the market (and these headlines are always easy to find). The power of loss aversion may lead us to sell our investments at the worst possible time.
Investments seem more much predictable after they have happened. After an event people often believe that they knew the likely outcome of the event beforehand. After every past decline it is straightforward to identify the opportunity, but certainly not at the time. Psychologists have shown that memory works more like an etch-a-sketch than being engraved in our memory. We often alter actual events in our memory, or erase them completely! When we look back at the financial crisis we identify the buying opportunity, but there was a lot of noise in the market at the time predicting worse to come.
So what can we do about this?
You can start an investment diary, in which you write down the reasons for making your investment decision. This allows you to accurately monitor the effectiveness of your decision-making process. You can also conduct a ‘pre-mortem’ (as the name suggests the opposite to a post-mortem) before making an investment decision. In a pre-mortem you write down why the investment might fail in the future, which can mitigate confirmation bias.
Checklists can help protect investors but are by no means the panacea. A checklist will be most powerful in gathering data beforehand, not just the mere fact of ticking boxes. Doctors and pilots use checklists, which significantly reduce the chance of human error in their professions.
Don’t trust your own instincts, trust an algorithm
We know that biases often lead us astray, which is why we make irrational decisions and often waver in their thinking. However, an algorithm never wavers. As Nobel Prize-winning behavioural psychologist Daniel Kahneman recently said: “Algorithms beat humans half the time, the other half they match us.” The best guide for how you will act in the next big market downturn is not how you think you will act, but how you acted in the last one.
What conclusions are we drawing from our mistakes?
We’ve all made investing mistakes that we have no intention of repeating. Can we just say that any mistakes were expensive lessons and move on? I know I’ve said this to myself before.
However, as Daniel Kahneman recently mentioned, when something happens we immediately understand how it happened. We feel like we have learned something and we tell ourselves that we won’t make the same mistake again. However, he suggests that we’re drawing the wrong conclusion. Kahneman says that the conclusion that we should draw is that “the world is more uncertain than you think”.
Ted Richards is the host of ‘The Richards Report’ an Australian investing podcast that covers the basics of investing without the usual jargon. He’s also a director of Six Park, who provides Australian investors with online investment management. Check out the Podcast here for itunes or here for Soundcloud.