The most overlooked aspect of investing is behavior. Instead, we focus on intelligence, timing, forecasting, and a host of other things we believe carry more weight in the returns we earn. Some of it matters, but not nearly as much as we hope.
Of course, Ben Graham tried getting the importance of behavior across decades ago. He plainly explains it in the introduction to The Intelligent Investor: “For indeed, the investor’s chief problem — and even his worst enemy — is likely to be himself.” If you can overcome yourself, you’ll be better off than most investors.
Here’s the thing.
Humans have been hardwired over the centuries with quick natural responses that enhanced our survivability. Thousands of years ago, survival required focusing on what’s around the corner instead of what’s far off in the distance. So we became great at leaping to the first conclusion rather than thinking things through.
That works great if we want to avoid being mauled by an animal, but works terribly if we want to survive in the stock market. Simply, human nature hasn’t kept pace with our changing environment.
That’s not to say we’re all screwed. Our natural tendencies still have some uses. But when it comes to investing (and a few other areas), these biases drag down performance.
In The Little Book of Behavioral Investing, James Montier covers the many ways we’re our own worst enemy when it comes to investing. It’s not comprehensive but it is a condensed (and dense) list of popular behavioral mistakes often repeated by investors. What follows is a break down of those biases and how to survive them:
- Empathy Gap — we have a hard time predicting how we’ll act during some future stressful event. We overestimate our intellectual abilities and underestimate our emotional drive. Planning ahead helps avoid emotional decisions in the heat of the moment.
- The Illusion of Control — we think we can influence the outcome and often mistake randomness for control. Also, the illusion of control enhances our optimistic tendencies.
- Self-Serving Bias — we tend to act in our best interests.
- Over-Optimism Bias — we tend to be optimistic by nature. We have a positive bias, believing good results will not only happen more often than bad results but will be better than expected.
- Overconfidence Bias — we tend to be more confident in our own abilities. We believe we’re above average — drivers, lovers, workers, investors, predictors of the future — even though we can’t all be above average. And we often confuse confidence in ourselves and others for skill. Even worse, we tend to believe people who sound confident even when they’re wrong. The solution to over-optimism and overconfidence is to be skeptical, disciplined, and always ask, “Why should I own this investment?”
- The Illusion of Knowledge — we confuse a surface understanding of something with a deep knowledge of it. The internet is a wondrous thing that perpetuates this.
- Confirmation Bias — we are more likely to look for information that agrees, rather than disagrees, with our conclusions, beliefs, and decisions. Sometimes confidence plays a neat trick where we discount disconfirming evidence as “wrong.” Sometimes we’re willfully blind to it. Sometimes we twist it to support our conclusions. Willfully trying to prove ourselves wrong solves this problem. Ask the question, “What are all the ways this could go wrong?”
- Conservatism Bias — we’re slow to change our minds when new information arrives. In other words, we over-weight old information and under-weight new information even when new information is accurate.
- Sunk Cost Fallacy — we tend to allow past costs — like time, money, emotion, or effort — to affect decisions.
- Narrative Fallacy — we try to give meaning to random series of events or facts by weaving a story around it that forces a link of cause and effect rather than judging each individual event on its own merits. Stories are in constant supply in the stock market. Every stock covered in the media is given a story. IPOs literally go on a roadshow to spread their story. Then there are story stocks, which trade not on fundamentals, but hope and promise of future potential. All these stories can affect our views because almost all have an emotional pull to them. Even the daily market moves get stories. Yet, the day-to-day market fluctuations are mostly random. That still doesn’t stop everyone from trying to give meaning to the movements. The fictional stories might offer some certainty to the uncertainty of markets but it’s all nonsense. It’s best to just tune out the noise and stick to the facts.
- Myopia — we have an extreme focus on the short term.
- Inattentional Blindness — we’re blind to the obvious because we’re focused on something else.
- Self-Attribution Bias — we see success as the result of skill and failure as the result of bad luck. In fact, failure is often seen as the result of something out of our control or we might even blame it on someone or something else. Markets are full of scapegoats easily blamed for our own mistakes.
- Hindsight Bias — it’s the we-knew-it-all-along effect. After knowing the outcome, we believe it was more easily predictable than it was at the time. The only way around it is to keep a record of your reasons behind investment decisions and track the outcomes. Then you’ll know if it was due to skill (right for the right reasons), good luck (right for the wrong reasons), bad luck (wrong for the right reasons), or a mistake (wrong for the wrong reasons). It adds accountability to your original views before you learned the outcome.
- Action Bias — we have a need to do something instead of nothing. We love quick results. It’s why get-rich-quick schemes never go out of style. Also, we have a bias toward action and the urge to act is higher after a loss. So BE PATIENT! Discipline helps too. Also, trust in the process.
- Social Pain — we find it uncomfortable to go against the crowd even if the view is wrong. When we do, it can trigger emotional fear.
- Groupthink — we have a desire to conform that can be so that the group’s decision-making suffers immensely. It can spiral to the point that anyone with opposing views is shunned, leaving only those that share the same views.
- Introspection Bias — we believe we know ourselves better than we actually do.
- Fundamental Attribution Error — we tend to blame other people’s actions on their behavior while blaming our own actions on external factors.
- Loss Aversion — we hate losses about twice as much as we enjoy gains. Another way to put it is losses loom larger than gains. A short-term focus makes loss aversion worse since the randomness of markets in the short term can deliver brief periods of paper losses at any time. And constantly checking our portfolio means we’re more likely to notice said paper losses. So stop constantly checking your portfolio!
- Disposition Effect — we tend to sell winning investments and hold on to losing investments. One study of brokerage accounts found that investors held losing stocks longer than winning stocks, were almost twice as likely to sell winners than hold onto losers, and that the sold winners outperformed the held losers. Any number of biases — overoptimism, overconfidence, sunk cost, self-attribution — are behind the results. Simply, we hold onto losers in the hopes of a recovery and are worse off for it. Also, professional investors aren’t much better at this.
- Endowment Effect — we put a higher value on things after we own them than before.
- Status Quo Bias — we prefer things stay the same and show it by doing nothing. Believing something is worth more than the current asking price combined with a bias towards inactions results in a natural reluctance to sell. Of course, knowing when to sell is one of the hardest, yet most important parts of investing.
- Outcome Bias — we tend to judge past decisions based on the quality of the outcome rather than the quality of the decision. This is poor investing in a nutshell. It’s also how most people view gambling outcomes. Every decision has four possible results: good decision/good outcome (deserved success), good decision/bad outcome (bad break), bad decision/good outcome (dumb luck), bad decision/bad outcome (poetic justice). A hyper-focus on outcomes leads to general stupidity like higher loss aversion, a need to embrace certainty, embracing noise, and following the herd. See outcomes for what they are: the result of a good or bad decision…which you won’t know unless you judge a decision independent of the outcome. Also, having a good process helps.
If all of this sounds overwhelming, don’t worry. Most people believe these biases don’t apply to them. As if it wasn’t hard enough, we’re blind to our own biases.
The first step is humility. It helps get around the bias blindness. Next is to build better behavior into your investment approach. Using simple rules or checklists will help reinforce it.
Knowledge, alone, is not enough to improve behavior. Simply, knowing every behavioral bias won’t make you better behaved.
Changed behavior requires a change in habits. Using simple rules or checklists will help reinforce it. Changing habits work much like compounding. Small gradual improvements, over time, pay off in big ways.
Then focus on the process. That’s the key. The best investors do this purposefully to keep from falling back into poor habits.
This post was originally published on August 15, 2018.
Notes: The Little Book of Behavioral Investing by James Montier