As humans, our emotions have developed over thousands of years since the first homo sapiens appeared. However, despite this evolution and the advances in technology, we still have animalistic brains with many psychological biases.
When humans lived in caves and on treetops, these biases and emotional triggers protected them and helped them to survive. However, in the modern day world of finance and investing, these same triggers can cause humans to make poor investing decisions.
These biases are studied under the umbrella of behavioral finance. In this discussion, we will examine five commom psychological biases that occur when investing, in addition to a few ways to help mitigate them.
Confirmation bias
First is confirmation bias, which is the tendency to search for, favor and recall information in a way that confirms or supports one's prior beliefs, values or hypothesis.
In other words, people seek out evidence that confirms their existing beliefs.
An example of this is an investor who is bullish on a stock like Tesla (TSLA, Financial). They may choose to watch all the good coverage of the stock and ignore the critics. A dose of this narrow-minded approach can be useful, but also dangerous as important information can be ignored.
Image by business.blogthinkbig.com.
A great way of preventing confirmation bias is to seek information from a variety of reputable sources. You can also seek out credible people who disagree with you. This is called the Devil's advocate system and is popular at some large investment firms such as Ray Dalio (Trades, Portfolio)’s Bridgewater Associates.
For example, if your bullish on Tesla stock, it would be useful to read and study a bearish person's investing thesis on the stock, but make sure they are credible.
Recency bias
Next is recency bias. This is the tendency for recent experiences to carry more weight in our minds when evaluating the odds of something happening in the future.
For example, just after 9/11, many people were anticipating more terrorist attacks. However, it was probably one of the safest times to fly as security was higher and everyone was more vigilant.
As Warren Buffett (Trades, Portfolio) once said, “Investors project out into the future what they have most recently been seeing.”
This is why investors have a tendency to buy at the top of markets. Examples include the dot-com bubble and even cryptocurrency. As American economist Harry Markowitz said, “The biggest mistake a small investor can make is buying when the market is going up, thinking it will continue going up and sell when the market is going down.”
Keeping perspective and putting things into historical context to give you a big-picture view of a situation help in countering this bias. It also helps to look at the data and calculate the odds in order to make informative decisions.
Overconfidence bias
We have a tendency to overestimate our abilities and knowledge.
Multiple studies show this overconfidence bias in action. For instance, a study conducted in 2004 found that 93% of drivers believe themselves to be above average. This is, of course, statistically impossible.
In the stock market, this tendency may cause us to make bold bets with limited evidence and also to think we know more than other investors.
To combat this bias, investors should balance their confidence with a dose of humility and objectivity.
Home bias
Home bias is the tendency for investors to only invest in stocks of their own country or be overexposed to their home country.
A Morningstar study fournd that average american onvestors are 73% invested in U.S. stocks.
As the U.S. economy only accounts for half of the global equity market, this percentage should be closer to 50% for the best global diversification.
In Sweden, the bias is shown to be more extreme as Swedish investors have 48% of their money in Swedish stocks.
Sweden only accounts for 1% of the global economy.
A fun example of home bias is the English soccer team and its fans. As a Brit myself, I see it during every major tournament, where after winning a couple of matches the whole country "dares to dream" and gets very confident...until we lose at the knockout stages. Now every country supports their home team, but most are much more humble even with better players (Brazil, Argentina, Portugal, Spain, Italy, etc.). Oh well, maybe next year!
An ideal portfolio should be diversified globally with allocations based on the gross domestic product for each country. Investors should be objective as to avoid disappointing themselves.
Survivorship bias
Survivorship bias is a common logical error that distorts our understanding of the world. It happens when we assume that success tells the whole story and we don’t adequately consider past failures. As the old adage goes: “Don’t confuse a bull market with brains.”
Another way of putting this is just because you made great returns on an investment doesn’t mean the strategy you used was correct.
Preventing survivorship bias requires exceptional self-awareness, humility and objectivity. You should be able to confidently know the difference between luck and skill when it comes to investing returns or even losses. Sometimes you may experience an investment loss, but your strategy was good. In that case, it was just bad luck.
Final thoughts
We humans are emotional creatures and even the greatest investors of all time, from Buffett and Charlie Munger (Trades, Portfolio) to George Soros (Trades, Portfolio), all make these mistakes. However, awareness of these biases should help with the first step toward minimizing them in the future. Soros recommends keeping a journal where you can record why you made each investment decision, which may help cut down on repeating the same mistake in the future.
