8 Types of Biases and Their Importance to Investing!
Did you know that your biases are the toughest to get rid of?
Our nature and nurture have the greatest impact on our life. Where you grow up and your upbringing shapes your entire life and destiny. A small percentage of people have the ability to be bold. But most of us have a world view that is shaped right through our childhood.
For me, this has been the greatest revelation!
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Note: If you’re an advanced investor or have conquered your biases, you may not find much value in these emails. However, if you are the one who’s up for learning new concepts and be a good investor, please stay with me. Let’s learn regularly.
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I looked at my past investments and 99% of the losses were due to the inherent biases that I held towards the investment thesis or my deep values. Investing success is quite challenging considering that there are 1000s of parameters that may go wrong. It’s a giant wheel.
Studying this is the goal of a whole area of research called behavioral finance. Through an enormous amount of experimentation, psychologists and economist have attempted to answer the age-old questions:
Why do we hold onto losing stocks when our rationale for buying the stocks is gone?
Why do we sell winning stocks way too quickly?
Why do we resist making smart financial moves when we can easily see how beneficial they will be?
Why do we act so crazy with money?
Below are some of the most useful findings. Consider this a “cheat sheet” for avoiding these common investing mistakes:
#1. Anchoring or Confirmation Bias:
We like to have our opinions confirmed by others, especially so-called experts. Because of this, we search and find information, data and analysis that will confirm our opinion. I used to see YouTube videos about the stocks I owned and liked when the YouTubers talked positively about the investment or the stock while neglecting the negative aspects.
If you want to see this bias in action magnified, talk to someone who is bearish on stock prices. They will cite chapter and verse of all the doom and gloom columnists who share their opinion and drag out charts, graphs and slide shows that clearly demonstrate how and why the world is going to end. They have their opinion, and it’s confirmed by others. Any evidence to the contrary will be ignored. That’s why I try to keep things objective – and go in with the same set of Moneyball criteria that’s responsible for all the best wins of my career.
#2. Gambler’s Fallacy:
There is a tendency among people to think that when a coin has been tossed five times and it lands on heads five times it is much more likely to land on tails the next time. This is totally incorrect. The odds of it being tails are exactly what they were the first five times: 50-50. Each flip occurs separately and independently of the others. It doesn’t have to land on tails. And just because the market has been up or down the past several days doesn’t necessarily mean it has to do anything one way or the other.
#3. Hindsight Theory:
When we look back over history, we tell ourselves that we knew something was going to happen before it did. The internet bubble that burst in 2001 is a powerful example. Everyone now claims that they saw it coming. They just knew that the market had reached unsustainable highs and that the bubble would burst and take all the high-risk investors and day traders to the cleaners.
The same thing is happening now. The markets are at the top and many so-called ‘experts’ are saying it is too hot and the market may crash anytime. If you are following one of these experts, you may as well sell the stocks. But at this moment, you will require some Stoic knowledge.
So if everyone knew in advance, then how come they all lost money? Almost no one admits that they hung around for the whole ride and lost money in the dot-com meltdown, yet millions of people lost billions of dollars in that time frame.
The same thing happened with bitcoin. I have been a proponent of bitcoin since 2014-15. The so-called ‘experts’ said there would be an imminent crash…since the day it was 1$. Had you heard these experts, you’d be regretting your choices.
You and you alone are responsible for your financial investments. NO ONE ELSE!
#4. Rearview-mirror Effect:
We tend to be most influenced by what has happened recently instead of what is happening right now. As the market goes higher, individuals (and institutions – after all, mutual funds and hedge funds are run by humans) tend to become more and more bullish; when the market has sold off for an extended period, they become more and more reluctant to buy. Yet if I find a great company that meets my criteria, I say that’s all the more reason to buy.
“Everyone has hindsight; very few have foresight.”
I remember a stock that I was eyeing in India for a long time; however the valuations did not make sense. It was Tata Elxsi. I knew they were a great company and worked with EV (Electronic Vehicle) manufacturers. In the crash of March 2020, I got a great opportunity as the stock plummeted. Nothing fundamentally had changed with the company. They were continuing with same contracts. Today, I am sitting at a 300%+ gain in that.
There are some other stocks that I invested in which have given much higher returns. I will cover them in upcoming emails.
#5. Self-attribution Bias:
We have a tendency to congratulate ourselves for our own brilliance when we succeed, but blame outside influences for our failures. When a stock we picked goes up, it is because we are clever and made the right choice. When a stock we picked goes down, it’s the economy, the Federal Reserve, the stupid broker or those gosh-darned hedge funds that made things go wrong. In my office, we refer to this as confusing a “bull market for brains.”
‘LOL” (I have done this so many times…not anymore. Remember, you are the only responsible person for your investments)
#6. Disposition Effect Bias:
One of the worst tendencies of investors is to sell winners far too soon and hold on to losing stocks. The old saying, that you can’t go broke taking a profit, has killed more investor portfolios than Attila the Hun did Romans. If you take 5% to 10% profits on your winners but continually take huge losses on your losers, holding onto the belief that it will come back, your overall results will look pretty bleak.
The flip side of selling winners too soon is just as dangerous. I call it “falling in love.” You can show love to stocks, but stocks can’t love you back. When they become too risky, you simply have to sell them and move on, even if they have made you rich.
We usually become ‘long term investors’ when the stock we invested in goes down.
#7. Familiarity Bias:
This happens when an investor focuses on familiar or well-known investments even though more gains can be made through diversification. As a result, this can lead to poor performing portfolios and a greater risk of losses. Instead, my whole goal is to find lesser-known stocks – with much better growth prospects than the “usual suspects” you hear about on TV every day.
#8. Trend-chasing Bias:
Past performance does not indicate future success. So, just because a company did well in the past does not mean that that trend will continue.
Right now, SPAC (Special Purpose Acquisition Company) are a great trend happening in the US. Lot of investors are giving in to these investments rather than understanding the actual products. (More about this in the upcoming emails!)
Happy investing,
Deepak
PS: Note, the email is inspired by many online articles.