Did you know that investors with the most intense emotional reaction to gains and losses had the worst investing performance of all? Now you might think ‘that’s not me, I have control over my emotions.’ – Well, that’s what I thought as well. But then I stumbled upon ‘behavioural biases’. Behavioural biases are basically shortcuts that our brain makes in order to make decisions much faster, but they also lead to A LOT of mistakes.
When I first learned about these behavioural biases I was shocked. I never realized how much impact they had on me. So I decided to dive deeper into the topic and this article is the end result. I bundled the 7 most common emotional biases that impact investors, so that you can prevent these biases from hurting your investment returns.
The Confirmation Bias
The second we see something, we unconsciously form an opinion about it. Just think about it for a second.. When you meet a new person, you immediately form an opinion about him or her. When we see the cover of a book, we immediately we form an opinion about how good or bad it is (hence the saying ‘don’t judge a book by its cover’). This is completely normal as it’s simply a shortcut made by our brain. If thousands of years ago we would’ve been too slow to form an opinion about something, it could have been fatal.
However, when it comes to investing, it can be fatal if we rely on this shortcut of our brain. This is because our brain is hardwired to stay consistent with the initial beliefs we have. Therefore, our brain will seek out evidence that supports our beliefs and this is especially dangerous when investing.
I’ve had situations where I really liked a company in particular and before I even started analysing it, I had the subconscious thought ‘I want this stock in my portfolio’. Because of this belief, I disregarded a couple of red flags while over-emphasizing their good points. Lessons learned..
A Great Video Explaining The Effect of The Confirmation Bias On Investors
The next time you are doing your due diligence on a company, write down the thoughts you have prior to starting your analysis. This way you can quickly identify if the confirmation bias is affecting you.
Another way to fight the confirmation bias is by playing devil’s advocate. Take the complete opposite standpoint and then analyse whether you still have the same believes or not (or have someone else take this standpoint).
Did you know that losses weigh twice as heavy as gains? It turns out that if we lose $10 we are impacted twice as hard compared to a $10 gain. This is what is called ‘loss aversion’ and it is one of the most dangerous pitfalls for investors.
If you’ve ever heard (or thought) ‘better safe than sorry’ or ‘I should take some of my profits while I still can’, it’s the result of loss aversion.
Let’s do a small test to see if you are loss averse :
Imagine that you have 2 stocks in your portfolio. Stock A, which is up by 30% and stock B which is down by 30%. You must sell one. Which one would you sell?
If you have picked stock A (like most people) this is the effect of the loss aversion bias. It’s your brain that refuses to take the loss because it does not want to acknowledge the pain of a loss. Simultaneously it wants to lock in some profit as this gives us a feeling of certainty. However, when we would look at things rationally we would often be much better off by holding on to our winners (as they are better companies for example) and selling our losers.
Most investors end up holding on to the worst stocks and selling their winners because they want to avoid losses. They are loss averse.
As legendary investor Philip Fisher wrote in his book
Common Stocks and Uncommon Profits and Other Writings
“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.”
Be aware that there is a big difference between a bad decision and a temporary bad outcome. If you have made a bad decision, it means your thesis was wrong and you should admit this as soon as possible. This is a case where you should definitely not hold on to your losers.
A temporary bad outcome is a situation where your analysis is solid, but the market simply didn’t recognize it yet. This is often the case in value investing, as the stock price will decline or stay flat for a couple of years before it ends up increasing. Legendary value investor Peter Lynch said that his most successful investments take about 3 – 7 years to work out.
So if you still feel your thesis is correct, you should hold on to your investment. Only if you come to realisation that your thesis was wrong, you should sell as soon as possible and not ‘try to break even’, as Philip Fisher said.
- The Representativeness Bias
One of the most common misconceptions of (beginning) investors is that :
A great company = A great investment.
While both are definitely linked with each other, you can never be sure that an investment in a great company equals a great investment. You still have to take an important aspect such as valuation into account. If you pay a price that is too high, your investment is still likely to fail.
I find Netflix an absolutely great service and I use it weekly, but I wouldn’t invest in their stock. I also find Snapchat a great app, but I wouldn’t invest in their stock either. There are many more companies that I like but would never invest in, simply because their valuation is too high or because I don’t see a lot of potential for steady profit.
Representativeness is also the reason why many investors avoid ‘boring’ companies, as they assign this negative characteristic with a negative outcome. In reality, the most profitable investments are made in the most boring and simplistic companies.
Coca-Cola is a perfect example of a simple and somewhat boring company, but it’s made a lot of investors very rich, including Warren Buffett.
- The Overconfidence Bias
Overconfidence is probably the most common behavioural bias that a lot of investors suffer from. Overconfidence leads us to believe that we are more capable of picking winning stocks than we actually are. Because of this overconfidence, we could be prone to making more investments, as we tend to believe that we have picked the next Microsoft more often. In reality however, it turns out that increased activity leads to lower returns. Study after study found a direct correlation between increased activity and decreased returns.
Therefore, try to be very conservative and strict when you are looking to invest in a company. Try to come up with all the point why you could be wrong (or let someone else do so). This way, you are forced to look at the company from different perspectives and you may even find out that you could better stay away from it.
Another way to combat the overconfidence bias is by limiting the amount of investments you make. Warren Buffett and Charlie Munger are known for making only a handful of investments each year, and some years they even make no investments at all. By limiting the amount of investments you make, you force yourself to only invest in the very best opportunities that come along.
PS : one of the best books I have read about these behavioural biases is The Little Book of Behavioral Investing: How not to be your own worst enemy. It’s a must read if you want to maximize your investment returns!
- The Excessive Optimism Bias
As an investor, you are likely to be quite optimistic. You probably wouldn’t invest your money if you weren’t optimistic about the future of a company. A healthy sense of optimism is great (for all walks of life), but an optimism overdose can be very dangerous.
Excessive optimism can lead us to invest in a company that we really shouldn’t invest in. Personally, I’m a true optimist, which resulted in some costly mistakes. I invested in companies that were ‘good’ but not ‘exceptional’.
I learned to counter this excessive optimism by writing down all the reasons why my investment won’t work. This way, I make sure I take a critical look at the company I am analysing, which definitely saved me some mistakes. I now only invest in companies that truly meet my strict requirements, even if that means making just 1 – 3 investments a year.
- The Herding Bias
Herding is a very common behavioural bias that occurs in every walk of life, but especially in investing. Herding is a completely normal human thing to do. We essentially live in herds every day.
The city we live in is a herd, our family is a herd, supporting your favourite sports team is a form of herding. Herding is what we do every day because it makes us feel comfortable.
It actually turns out that people are so sensitive to herd behaviour that we are willing to go completely against our own rational thinking when the herd is saying the same thing, as we can see in the video underneath.
Asch Conformity Experiment
Herding is exactly why bubbles occur every now and then. People massively follow each other and are influenced by the enthusiasm of other investors. It is hard not to be affected when people around you (whether that is on the internet, TV or at a cocktail party) are all hopping on ‘the next big thing’.
Successful value investing is all about seeing what most other investors do not see (or do not dare to act on). Just like sir John Templeton said :
“If you want to have a better performance than the crowd, you must do things differently from the crowd.”
If you stay with the tribe, ugly things may not happen to you. But of course, if you stay with the tribe, great things also won’t happen to you either. Get comfortable going into no-man’s or standing alone with your opinion.
While noise is not really a behavioural bias, I included it in this article since it has a profound effect on investors. Noise essential covers the thousands of different opinions and media stories that affect your own thinking. By being exposed to noise we make it hard for ourselves to form our own opinion.
Every news story or opinion we consume has the tendency to affect us. It actually turns out that our brain is heavily affected by the most recent opinion or news story we come across, as recent information is seen as more important than it actually is. This behavioural bias is called the ‘recency effect’.
Oftentimes the news coverage is dramatized because this boost their views. These dramatic stories have a serious impact on our investing decisions as our brain is hardwired to see dramatic information as more important than it actually is. This behavioural bias is called the ‘saliency bias’.
My advice is to limit the amount of time you expose yourself to media coverage about the stock market. Remember, it only exists to entertain you, not to inform you.
Take Emotions Out Of The Equation
Just like Warren Buffett said, the key to successful investing is to minimize the effect of emotions.