To be a successful investor over the long term, we believe it is critical to understand, and hopefully overcome, common human cognitive or psychological biases that often lead to poor decisions and investment mistakes. Cognitive biases are ‘hard wired’ and we are all liable to take shortcuts, oversimplify complex decisions and be overconfident in our decision-making process. Understanding our cognitive biases can lead to better decision making, which is fundamental, in our view, to lowering risk and improving investment returns over time. A few of the key cognitive biases that can lead to poor investment decisions have been described briefly below:
1. Confirmation bias
Confirmation bias is the natural human tendency to seek or emphasise information that confirms an existing conclusion or hypothesis. In our view, confirmation bias is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong. To minimise the risk of confirmation bias, one must attempt to challenge the status quo and seek information that causes us to question our investment thesis.
2. Information bias
Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. The key in investing is to see the wood from the trees and to carefully evaluate information that is relevant to making a more informed investment decision and to discard (and hopefully ignore) irrelevant information. Investors are bombarded with useless information every day, from financial commentators, newspapers and stockbrokers, and it is difficult to filter through it to focus on information that is relevant. In our view, this information is more harmful than useful. In many instances, investors will make investment decisions to buy or sell an investment on the basis of short-term movements in the share price. This can cause investors to sell wonderful investments due to the fact that the share price has fallen and to buy into bad investments on the basis that the share price has risen. In general, investors would make superior investment decisions if they ignored daily share-price movements and focused on the medium-term prospects for the underlying investment and looked at the price in comparison to those prospects. By ignoring daily commentary regarding share prices, investors would overcome a dangerous source of information bias in the investment decision-making process.
3. Loss aversion bias
Loss aversion is the tendency for people to strongly prefer avoiding losses than obtaining gains. Closely related to loss aversion is the endowment effect, which occurs when people place a higher value on a good that they own than on an identical good that they do not own. The loss aversion or endowment effect can lead to poor and irrational investment decisions, whereby investors refuse to sell loss-making investments in the hope of making their money back. To be a successful investor over time you must be able to properly measure opportunity cost and not be anchored to past investment decisions due to the inbuilt human tendency to avoid losses. Investors who become anchored due to loss aversion will pass on mouth-watering investment opportunities to retain an existing loss-making investment in the hope of recouping their losses. In our view, all past decisions are sunk costs and a decision to retain or sell an existing investment must be measured against its opportunity cost.
4. Oversimplification tendency bias
In seeking to understand complex matters humans tend to want clear and simple explanations. Unfortunately, some matters are inherently complex or uncertain and do not lend themselves to simple explanations. In fact, some matters are so uncertain that it is not possible to see the future with any clarity. In our view, many investment mistakes are made when people oversimplify uncertain or complex matters. A key to successful investing is to stay within your ‘circle of competence’. A key part of our ‘circle of competence’ is to concentrate our investments in areas that exhibit a high degree of predictability and to be wary of areas that are highly complex and/or highly uncertain.
5. Hindsight bias
Hindsight bias is a tendency to see beneficial past events as predictable and bad events as not predictable. Hindsight bias is a dangerous state of mind as it clouds your objectivity in assessing past investment decisions and inhibits your ability to learn from past mistakes.
6. Bandwagon effect bias
The bandwagon effect, or groupthink, describes gaining comfort in something because many other people do (or believe) the same. To be a successful investor, one must be able to analyse and think independently. Speculative bubbles are typically the result of groupthink and herd mentality. We find no comfort in the fact that other people are doing certain things or that people agree with us. At the end of the day, we will be right or wrong because our analysis and judgement is either right or wrong.
7. Anchoring bias
Anchoring bias is the tendency to rely too heavily on, or anchor to, a past reference or one piece of information when making a decision. There have been many academic studies undertaken on the power of anchoring on decision making. Studies typically get people to focus on a items such as their year of birth or age before being asked to assign a value to something. The studies show that people are influenced in their answer, or anchored, to the random number that they have focused on prior to being asked the question.
8. Recency bias
Recency bias is the tendency to place too much emphasis on experiences that are freshest in your memory—even if they are not the most relevant or reliable. In the investing world, recency bias can be hard to avoid. Investors often display recency bias when they make decisions based on recent events, expecting that those events will continue into the future. It can lead them to make irrational decisions, such as following a hot investment trend or selling securities during a market downturn. Recency bias can lead clients to deviate from their carefully laid investment plans, which can have damaging long-term consequences. To combat recency bias, one needs to take a broader view of how markets tend to move over time and the larger trends that may have the biggest impact on their investment returns
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