Biased Decision Alert!

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:

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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

  • 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.


Market participant shall be good at:
// KYB [Know your business - Use Fundamental Analysis]
// KYC [Know your competitors - Use Technical Analysis], and
// KYS [Know your Self- Use Behavioral Analysis: Below checklist pertains to this category. As it’s WIP, feel free to add more from your experiences]

Behavioral biases – Mental shortcuts that cause non-optimal decisions due to lack of mathematical skill and memory limitations or emotions-based choices. Two types - Cognitive and Emotional.

Cognitive Errors: These are information-processing, or memory errors. How to Mitigate? Develop a systematic process to describe problems and objectives; to gather, record, and synthesize information; to document decisions and their rationale; and to compare the actual results with expected results. What are the various types of Cognitive Errors?

  • Conservation: Maintaining original view even in the presence of new negative information.
  • Confirmation: Excessive weightage to the information that reinforces self-belief.
  • Base-Rate Neglect: Ignoring or underweighting normal probability of the suitable reference classes in decision making.
  • Sample-Size Neglect: Basing decision on small or inappropriate sample size.
  • Illusion of control: Overweighing self-ability to influence the outcome.
  • Hindsight: Judging decision on the basis of its outcome.
  • Anchoring and Adjustment: Estimating a number basis a suggestion that’s in immediate attention.
  • Mental Accounting: Treating money differently by assigning it to different mental buckets.
  • Framing: Answering differently due to subtle suggestions in the question.
  • Availability: Overweighing events (recent and vivid) that are easy to recall.

Emotional Biases: These are errors caused by impulse, intuition and feelings [FII]. How to Mitigate? Enlighten the investment decision making process using appropriate questions. For example- How would you invest if received the amount as cash instead of the current form? Are you okay with earning a low return on your investments? What’s the objective basis to stay invested? What are the various types of Emotional Biases?

  • Loss-Aversion: Weighing losses (2x) more than gains. Example – Hold loss making position with the hope to breakeven and book the gains early.
  • Overconfidence: Excessive faith in one’s judgement and reasoning abilities due to illusion of knowledge (considering self as smarter and well informed) and self-attribution tendency (credit self for good outcomes and blame others for bad outcomes). Mitigation - Implement a conscious review process to demonstrate the effectiveness of the decision-making ability.
  • Self-Control: Weighing instant temptations more than the long-term benefits. Example – Prefer income today instead of a lump-sum amount in the future.
  • Status Quo: Inertia to action. Example – Opting for default options while selecting a car insurance .
  • Endowment: Valuing owned assets, which are not meant for trading, higher than their true market value. Example – Assigning more value to the wine after buying in an auction setup than before buying.
  • Regret-Aversion: Conscious choice of inaction fearing regret that one faces after a decision that leads to a bad outcome. Two Dimensional – Error of Commission and Error of Omission. Examples – Holding a position fearing that it may go up after selling.