Being a great investor requires more than having a solid grasp of the fundamentals of company valuation. Being a good investor also requires you to understand the forces that lead others (and yourself!) to make irrational decisions.
Warren Buffett (Trades, Portfolio)’s partner Charlie Munger (Trades, Portfolio) has spoken about this on many occasions, most notably in a 1994 address at the University of Southern California (USC) entitled "The Psychology of Human Misjudgement."
Following in Munger’s footsteps, here are two cognitive biases that I think value investors need to be on the lookout for when deploying capital
Anchoring bias
This refers to the phenomenon where an individual becomes overly reliant on the first piece of information that they hear about a subject. This can be seen in retail, where buying a $100 pair of shoes that have been marked down 25% to $75 feels like a better deal than a situation where those same shoes are priced at $75 to start with. In both cases, the item is the same, as is the amount paid, but countless studies have shown that customers are much more likely to make the purchase when the item has been marked down. The initial piece of information, i.e. the $100 price, is the "anchor" - it provides the context for how the rest of the transaction is analysed.
Anchoring biases occur in investing all the time. The knowledge that a stock is trading at its all-time low doesn’t necessarily tell you anything about its valuation. Maybe its fundamentals have deteriorated to the point where such a low stock price is justified. But just having the knowledge that "it has never been this low in twenty years' time" makes investors more likely to buy a stock. This is exactly the sort of dangerous thinking that value investors need to be wary of.
Blind spot bias
Unfortunately, dangerous thinking is often difficult to spot in oneself. The reason for this is the second cognitive bias I wanted to discuss today - the blind spot bias. Why is it that people are so good at pointing out the flaws in others, and yet cannot correct their own flaws? The simple answer is that they are blind to their own failings. This applies as much in life as it does in investing.
It’s quite easy to critique someone else’s investment process and to explain why they are wrong. It’s much harder to self-critique - after all, people generally try not to make mistakes, so whatever failings we do have tend to be hidden pretty well from us.
How do we overcome this blind spot bias? The easiest way to do this is to have a peer or colleague tear apart your investment theses and try to find as many holes in them as possible. The catch here is that you have to actually listen to their insights. In doing this exercise, you will probably be exposed to flaws in your thinking that you didn’t even know existed, and you’ll be a better investor for it.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: How Management Can Game Depreciation Figures
- Howard Marks: Is 2020 Like 2008?
- Guggenheim's Chief Investment Officer: Stocks Will Continue to Rise
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