We all make decisions in our investment operations. Some well thought out decisions, some knee jerk reactions. But what we don’t realise is almost every decision we make is biased in one way or the other, which invariably leads to suboptimal decision making processes and effectiveness. And the worst part is, these biases are such stealthy little trouble makers that we can’t even appreciate how quickly and how much they’ve grown on us. But that’s where this piece comes in. This piece is a handy little cheat sheet on investment biases and how to deal with them.
In his book, The Little Book Of Behavioural Investing, the author James Montier has eloquently explained and laid out a number of biases that investors commonly and unknowingly face. The most important ones among them, and remedial measures for each of those biases are covered below:
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Confirmation Bias: We invariably have preconceptions when we look at a company. And we then look selectively for information and data to further support our stance on the company, while completely ignoring information to the contrary, to lull ourselves into a false sense of security that we’re taking the right call. Remember not to have preconceptions and to objectively assess all the information about the company we pick, whether positive or negative.
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Self Attribution Bias: If we’re perfectly honest with ourselves we would ideally admit that we sometimes have hit the target with an arrow that we shot in absolute darkness. But we invariably put down gains from investments which we earned by way of sheer dumb luck, down to our own smarts, to showcase the idea that we know what we’re doing. To avoid doing this, be honest enough to admit when you get lucky, and focus on developing a logical decision making process rather than just focusing on the outcome.
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Regret Aversion Bias: We always try to hold on to a losing stock in our portfolio, no matter how much of an adverse effect it has on our returns, just to avoid facing up to the fact that we made an error in judgment when we allocated a portion of our capital to the stock. Never be afraid to own up to mistakes, because that is the starting point on the journey to being a wiser investor.
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Disposition Effect Bias: We tend to discriminate between stocks in our portfolio, by labelling some as winners and others as losers, without giving them a fair chance, just because of tepid or great performance in the short term, and then we end up selling the perceived losers way too early, and what’s worse, these perceived losers may go on to be the biggest winners, and vice versa. So, stay away from labelling stocks either way based on short term performance.
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Hindsight Bias: Imagine that we make a substantial profit on a stock and we sell it. Just after we sell it, the stock shoots up by 20%. We look back on our decision to sell, and curse ourselves for having sold too early. This is hindsight bias. Remember to not be too greedy and celebrate the gains made, rather than be envious of the gains that get away.
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Familiarity Bias: Warren Buffett has always championed the cause of staying within one’s circle of competence. But we sometimes take this advice too far by over concentrating our capital between a few companies in the same sector or industry. Remember that a moderate amount of diversification is always healthy for a portfolio. Buffett himself supports the idea of a 15-20 stock portfolio
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Trend Chasing Bias: At any point of time in the markets, there is always one particular set of stocks that catch the fancy of the markets for certain reasons. Investors blindly buy into these stocks without checking to see if there is actually any fire at the base of all the smoke. Remember to be a contrarian in these situations. This is painful at first, but in the long run, it always pays to be a trend setter rather than a trend follower.
So that’s the end of the cheat sheet. If you find that you have any of these biases, don’t worry one bit. Now is as good a time as any to start working on them. And don’t work on all your biases at once, work on one bias at a time. And don’t expect the change to manifest itself overnight. Take it easy, give yourself time, and you’ll eventually get there.