In the final post of this 3-part series we’ll cover a variety of traps and biases the individual investor will inevitably stumble upon. Behavioral finance has shown investing can be just as much about the person as it is the numbers and often investors are their own worst enemies. I want to cover quite a few of these emotional snares in this article so you can identify and avoid them in the future.
- Positive traps & biases
- Negative traps & biases
- Thoughts on how to avoid
Positive Traps & Biases
I’ve broken the psychological and emotional pitfalls down into two sections in order to keep them easier to remember. Positive traps and biases will cover more optimistic thought processes while negative will include the more pessimistic side.
“The problem with the world is that the intelligent people are full of doubts, while the stupid ones are full of confidence.” -- Charles Bukowski
Overconfidence - Potentially the most dangerous emotion. To put it bluntly, we have a tendency to believe we are much smarter and much more capable than we really are. While it's only human nature it can be very hazardous nonetheless for investors to assume they're great at picking stocks. Numbers back this up as studies have shown when we say we're 90% sure of something, we're right about 70% of the time. Instead of assuming you're brilliant and can pick excellent stocks out of a hat, practice a value investing approach and diligently select stocks based on fundamentals and value.
Anchoring - The tendency to "anchor" thoughts on a reference point that may have no relevance to the decision on hand. Investors commonly get caught in this trap focusing on recent performance, or price paid, all too often. When reviewing or valuing a company one can get "anchored" on one's own valuations, a company's earnings, or even analyst sentiment. This can lead to purchasing and holding on to stocks purely based on emotion and not analysis.
Confirmation Bias - Another risk that stems from both overconfidence and anchoring is confirmation bias, or the act of selectively filtering information that supports an original opinion. For instance, investors may seek out data that backs up their initial decision to buy a stock rather than analyzing if they might have made a mistake. This type of behavior also leads to us adjusting our reasoning for purchasing a stock in the first place. This is dangerous and inhibits us from viewing our decisions as objectively as we should.
Selective Memory - Yet another danger overconfidence may lead to, selective memory is the art of remembering the past inaccurately, selectively picking out the parts that suit our needs, or buffs up our self-image. This is a fatal flaw because it means we can never learn from our mistakes, a terrible thing in the world of investing.
Negative Investing Traps & Biases
Loss Aversion - As you’ve learned with prospect theory, most of us are naturally loss averse. But here we’re talking about our inclination to become obsessively focused on one investment that’s losing. Once we realize we've made a mistake, or figured out the company has soured, we just can’t bring ourselves to sell due to the regret and pain of the decision. Just as prospect theory explained, it doesn't help that the pain of loss stings much worse than the pleasure obtained from gains. This can lead to holding "losers" far too long.
Sunk Costs - Another loss aversion factor is sunk costs, which is when one becomes too fixated on costs from a previous decision that are unlikely to ever be recovered. The inability to ignore these "sunk costs" of poor investment decisions causes us to fail in future evaluations. Even if business operations sour or fundamentals deteriorate, investors will hold onto stocks for far too long, unable to shake the effect of sunk costs.
Handicapping - Self-handicapping bias occurs when we try to explain any possible future poor performance with a reason that may or may not be true, and can be considered the exact opposite of overconfidence. An example would be an athlete saying their back hurts before a big game in order to have a potential excuse if they didn't play so well. It’s the same concept for investors. We may say we didn't really do our proper homework before buying a stock, just in case it performs poorly, rather than acknowledging there is an insufficiency in our process.
“More money has probably been lost by investors holding a stock they really did not want until they could at least come out even than from any other single reason.” -- Philip Fisher
Thoughts On How To Avoid
The bottom line is the field of behavioral finance has a major impact on all investors. Regardless of what factors that stand out, we've all been guilty of at least one of these traps, or biases, or other type of irrational behavior. Being aware of and identifying these influences can make it less likely you will succumb to them.
All of these emotions and psychological tricks lead to hesitation and indecision - two silent assassins of successful investing. So utilize a value investing philosophy as well as tools to keep your investing approach as businesslike as possible. Consider a checklist for example. Design a process where you focus on fundamentals, make decisions based on valuation, and leave emotion behind. Also remember to review yourself and see if you can find any of these traps or biases in your current approach.
- Several positive traps stem from overconfidence, or the tendency to believe we are much smarter and much more capable than we really are - especially when picking stocks
- Negative traps and biases on the other hand comes from our innate aversion to loss, which can result in holding "loser" stocks for far too long
- Practice a value investing approach that focuses on fundamentals and valuation, leaving emotion where it belongs - out of the picture