If someone were to pick you up in a helicopter, put blinders over your eyes, then drop you into the middle of a jungle, it’s likely you’d have a tough time
lasting for any length of time. Undoubtedly, it’s hard enough surviving in the jungle, let alone with blinders on. The stock market is a lot like the
jungle - it’s a dangerous place for those who don’t know what they’re doing, or even those who think they know what they’re doing. It isn’t a far stretch
to see how biases (a.k.a. “blinders”) can compound the challenges posed by the wilderness of the markets.
When it comes to investing, we all have the same biases. This is because our brains have all evolved the same way. The trick is to be able to recognize our biases in our decision-making processes and work on countering them
with the right behaviors.
Bias #1: I know enough, therefore I know better We all like to think that we are not as influenced by biases as other people are, which is our first and biggest investing mistake. Even professionals in
the financial industry have biases that lead them to make less-than-optimal decisions. In fact, the more we know about a subject, the more confident we are
that our forecasts will be correct. The reality is that information quantity is no match for quality; it’s not about how much you know, but what you do
with the information you have.
So let’s get one thing straight: you know less than you think you do when it comes
to investing, and that’s not a bad thing. You will never know all there is to know about the markets, and you will never gather enough information to give
you certainty that an investment will perform the way you want it to. What really matters is separating the facts from the stories. Check your sources when
you research an investment, and make sure they’re credible and reliable. Also, don't take information at face value. Instead, think carefully about how it
was presented to you.
Bias #2: I see what I want to see Another big problem of ours as humans is that we tend to seek out information that confirms our beliefs rather than challenges them. It makes us feel good
to listen to people who share our views, which means that we are likely to dismiss negative information on an investment that we favor. What’s even more
interesting is that we tend to view information that contradicts our beliefs as biased itself.
To counter this thought process, we need to constantly seek out information and people that disagree with us. This is not because we want them to try and
change our minds, but because we have to be able to understand and deconstruct the logic of the argument. If we can’t see the argument’s flaws, we should
seriously reconsider our viewpoint.
Bias #3: Numbers are my anchor Anchoring is a term used to describe the tendency for us to stick closely to numbers that are presented to us. The most common example of this is anchoring
to share prices. When we see a share price of, say $10, we tend to immediately believe that it reflects the underlying value of the company. Because
today’s markets are highly liquid, company values don’t tend to stray significantly from their share prices. However, it is nevertheless important to come
to your own conclusions about the value of a company. If there is a significant deviation between your evaluation and the share price, you may have a trading opportunity on your hands.
Bias #4: Good performance follows good performance You’ve likely heard the old adage, “past performance is not an indicator of future performance.” So why do so many investors - even analysts - make the
mistake of assuming that a good company with solid earnings over the past several years will continue to perform well? This belief stems from a type of
bias known as representativeness, which is a phenomenon where we use a company’s past and current performance to predict its future likelihood of
success. However, this bias can lead you down the wrong path, because future performance relies heavily on events and circumstances that will likely be
quite different than those that exist today.
The key here is to determine a company’s competitive advantage, which is the strongest predictor of future success. Most companies out there are or will
eventually become quite average, and over time, their performance will revert to the average. So you need to answer the question, “What qualities does the
company have today that substantially distinguish it from its competitors so that it will continue to perform well in the future?”
Bias #5: A loss isn't a loss until I take it The tendency to hold on to investments as they drop in price is all too common. So why do we cling to losers? There are several biases at play here. First,
we tend to value the things we own more than the things that we don’t. Whether it’s a coffee mug or 1000 shares of our favorite company, we prefer to sell
the things we own for more than many people are willing to pay for them.
The second and biggest reason we don’t sell investments as quickly as we should is
because of our aversion to taking losses. In general, we dislike incurring losses about 2.5 times more than we like making gains. We therefore tend to keep
our losers longer than we should, and cut our winners sooner than we should. We rationalize the decision to keep declining investments by telling ourselves
that the price will bounce back. Unfortunately, they tend to underperform the winners we have already sold.
The trick to avoiding this mental trap is to set up an investment strategy that requires you to buy and sell at pre-determined prices. To augment this
strategy, you can “taper in” and “taper out” of investments, depending on their price movements. For example, if you plan to buy 1000 shares of a stock,
start by purchasing 500 shares, then as the price moves in the direction you want it to go, buy 25% more. Continue to do so until you’ve reached your
maximum number of shares. This same strategy applies to selling stocks.
Easy to learn, hard to do Although it is easy to understand our biases, it is much more difficult to know when they are influencing our decisions. This is why planning your
investment strategy is so important. Planning allows you to predict scenarios before they arise and work out how to properly handle them. Don’t
underestimate your brain’s ability to trip you up. If it happens to professional money managers and analysts, it will happen to you.