Behavioral Bias: How It Affects One’s Investments by SG Investor

Virtually every investor makes emotional decisions. Why do we buy certain companies? Is it because it is one that we can relate to? Do we use their products like the Apple, Nestle, Coca-Cola etc. Essentially, every investor have committed this mistake of purchasing a company based on emotions.

In the short run, the market is a voting machine but in the long run it is a weighing machine

Benjamin Graham

Market prices for companies are mainly driven by emotion in the short run. Anyone who has been investing long enough would realise that the markets are irrational in the short run. There is absolutely no sign of rationality. Prices could be up 5% one day and down 7% the next. Does this mean the fundamentals of the company has changed over this span of 48 hours? The truth of a company lies in its operating results than its current stock price. That said, how does one still use this knowledge to outperform the markets?

As human beings, we would still tend to choose companies with superior returns and strong margins. Performance wise, individuals would not fair too badly using such a strategy. However, base of the fact of mean reversion, performance for investing in such “quality” companies would not outperform the markets. To really outperform the markets, it would be buying the companies trading at the cheapest decile of the stock market. However, more often than not, we are unable to stomach these companies when we try digging deeper into their financials.

What can us investors do?

Understanding our susceptibility to cognitive bias, we should remove the emotion factor out of our screening and decision process. I remember an interview of Mr. C. Thomas Howard and he said that he did not know any of the names in the fund he is managing.

Let’s manage portfolios recognising that we all, left to our own devices, will make these kinds of emotional decisions. I call it ruthlessly driving emotion out of your decision process. As ruthlessly as I can, I drive everything out of the decision process that is emotionally driven and has nothing to do with my investment process. That’s what we do in terms of managing money.

C. Thomas Howard

Personally, I believe that through quantitative methods of screening, it removes elements of cognitive bias. It prevents individuals from purchasing companies that are essentially too expensive otherwise known as glamour stocks. Too many a times, when individuals invest their money, they are investing in the story behind the company rather than the company itself. This method would essentially prevent this occurrence.

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However, one key factor to note is that we have to accept the results of this screening model we use. We should never try cherry-picking the companies that the model provides. By just picking companies that looks more superior and have higher growth would once again affect the performance of the model. As seen from the research above, it has been shown that using an automated simple model does far better than pairing the simple model with an inexperienced or experienced user.

One might wonder, by cherry-picking the companies that are already trading within the bottom decile of the stock market, how bad could the performance be. A research paper that I would recommend reading would be ‘Contrarian Value‘ produced by Lakonishok, Shleifer and Vishny. Essentially it has shown that the performance of the portfolio containing value stocks with low growth outperformed that of value stocks with high growth. However, these two portfolios would still outperform a portfolio that contains glamour stocks with high growth. Once again, this is due to the effects of mean reversion.

To end it off, investors have to be extremely careful when investing in companies. One has to ensure that our decisions are not influenced by our emotions but rather be based purely on logic and reasoning.

Clients like stories. For some reason, people want to like the stocks that they own. The only reason to buy a stock is to make money. Stocks are not friends. They’re not family. They’re there to make money. When you don’t think they can make money any longer, you get rid of them.

C. Thomas Howard