Economies are in a mess. Markets are in chaos. So whether you're bullish or bearish, it's all the more important to keep a cool head and make carefully considered, rational decisions.
The fact is, you probably don't. We all like to think that we make decisions based on logic, but emotion and psychology inevitably affect our thought processes. There's a large body of evidence from behavioral finance studies that indicate both private and professional investors are prone to psychological biases in their decision making. That leads to sub-optimal performance at best, and disaster at worst.
I've listed the five most dangerous biases below. Just being aware of these biases can improve your investment decision-making, but I've also suggested some practical steps to reduce the risk of succumbing to them.
1. Availability Bias
Availability bias is the natural tendency to give undue weight to more vivid or prominent facts. It's why we fear plane crashes more than car crashes, even though the latter are statistically more of a risk. Its kissing cousin is recency bias, the tendency to give more weight to facts most recently acquired.
In investment, availability bias frequently shows itself as an over-reaction to news. It's bad to buy a share straight after reading a tip or a relevant piece of news. Instead, it's good to thoroughly research a share and reach a considered view, then to buy as the market -- itself showing availability bias -- over-reacts to a piece of bad news.
2. Confirmation Bias
We don't just give more weight to recent facts, we also give more weight to facts that support our pre-conceived opinions. That's confirmation bias. While this psychological tendency no doubt helps politicians to sleep at night, it wreaks havoc in investment, where reaching the right conclusion matters more than how well you articulate your case.
The value of a share is a delicate balance between lots of positive and negative factors, and the investor has to judge what weight to put on each line. To help address this bias, think hard about the negative points, and be your own Devil's advocate. I tried this recently when I asked myself: "Just what's wrong with Aviva (LSE: AV)?"
Anchoring is the trait of being attached to a particular piece of information, and then interpreting other information to fit with it. In investing, the most obvious example is the market price: when we value companies we more often rationalise the market price than determine value from first principles.
Of course, the market price should reflect all the information about a share as interpreted by all investors, so this price does have a real meaning. But anchoring is dangerous when the price moves and your thinking remains stuck to what the share was once worth.
You're not overconfident, are you? Me neither. Modesty could be my middle name -- except it sounds a trifle feminine. But I guess I'm not alone here in striving to obtain better-than-average returns. The problem is, too many of us think we can be above-average for us all to be right. A 2006 study by James Montier found that three-quarters of fund managers believed they achieved above-average returns. Montier's paper has a fascinating self-test to reveal your own cognitive biases.
So overconfidence is a trait we all have to be wary of. It manifests itself as being over-optimistic: seeing the potential upside more than the downside risk. And it can lead to over-trading.
5. Loss Aversion
Psychological experiments have shown that people are more strongly motivated to avoid losses than to make gains. In investing, it gives rise to the disposition effect, which we have probably all felt: investors are generally much more reluctant to sell shares at a loss than at a profit.
Logically and dispassionately, it should not make a difference to the decision to sell when the price is either above or below what we paid. In classical economics, losses are sunk costs. But there are a couple of exceptions to that rule. Crystallising profits and losses can have a tax effect. And there can be good reasons to sell winners, for example to maintain the balance of a portfolio or if you anticipate the good times will soon be over.
Being aware of cognitive biases can help you avoid being over-influenced by them. Otherwise, taking a disciplined approach to investment is the best antidote.
I'm less disciplined than I mean to be, and that's less than I ought to be. This is real life. But I have a four-point plan to make myself act on cold logic:
Slow things down by always putting shares on a watch list before deciding to buy;
Go through a check list to force yourself to think about all the important factors;
Write down a brief investment thesis, with positive and negative points, and;
Have a stop-loss price. Even if this doesn't automatically trigger a sale, it should force you to revisit your investment thesis.
BY Tony Reading
Published in Investing on 8 November 2011