People’s cognitive biases affect every aspect of their lives, from their careers to their personal relationships, and everything in between. When it comes to investing, however, learning to control your biases may very well lead to better returns. Let’s take a look at a few of the most common biases, and some ways to overcome them in your investing.
1. Confirmation Bias
Confirmation bias refers to people’s tendency to focus only on information that supports their preexisting notions. For example, if you think biotech stocks are overvalued, you’ll search for, read, believe, and remember only the articles that confirm your belief. You’ll then simply ignore (or forget reading) articles that provide viewpoints to the contrary. This is highly dangerous behavior, because tunnel vision contributes to the age-old investing pitfall of sticking with losers and ignoring potential winners.
Try this: Pretend today is your first day as an investor. Forget any stocks that you currently own, or have ever owned in the past. Disregard your preferences for particular sectors or companies. Now, think about the current state of the markets. Consider what’s working now, what’s been working for the past 5 years, and the past 10 years. Next, think about what will continue to work for the next year, 5 years, and 10 years. Remember, your portfolio is empty. How would you begin to build up positions, and what would your portfolio look like?
If the answer is “My portfolio would like quite a bit different than it does now,” then congratulations! You’re on your way to overcoming confirmation bias. Now go read some articles that challenge your traditional beliefs about particular stocks or sectors, or even investing in general. Only through understanding the other side of the argument will you be able to justify your own position, and be able to ascertain whether your beliefs are valid.
2. Gambler's Fallacy
Gambler’s fallacy is the false belief that past events affect future probabilities. A non-stock example involves a bettor sitting at a roulette table and watching black numbers come up over and over again. The bettor mistakenly believes that since the ball has landed on black so many times in a row, that the odds of red coming up next are increasing. In reality, the odds are equal that the ball will land on either red or black on every spin, regardless of the current “streak.”
When the wheel is spun a great number of times (think several thousand), both red and black will come up an equal number of times. In smaller sample sizes, however, black or red can go on very large streaks. The ball could land on the same color dozens of times in a row, in fact.
Applied to the stock world, we can look at bottom fishing as an example of the gambler’s fallacy. Investors will look at beaten-up stocks as “cheap,” simply because they’ve lost so much value for so long. “This $1 stock used to be a $100 stock, so it’s due for a bounce, right?” In reality, stocks can and will go to zero. Bounces are in no way guaranteed, nor are they to be expected, even for one-mighty companies (think about the General Motors and Kodak bankruptcies, or even the current state of coal stocks for even more recent examples).
Try this: Research a single stock (pick any one). Don’t look at any charts or anything else that reflects the past. Instead, check out metrics and articles that are forward-looking: EPS/revenue estimates, potential growth opportunities, and projections for the company’s industry in general. Does the future look bright for the stock, or are its best days probably long gone already?
3. Normalcy Bias
Normalcy bias refers to people’s tendency to avoid planning for or reacting to disasters. Most people wake up each day expecting everything to be exactly the same, but we all know that’s not the way the markets work.
The markets change faster than ever these days, and especially after the incredible bull run we’ve had, it makes sense to prepare for the inevitable downturn. There’s no need
Try this: Imagine you could time travel back to late 2007, just before the last market crash took shape. How would you prepare? Once the pullback began, how would you react? How different are these plans than how you actually reacted? Understanding your previous failure to plan and react will help you to avoid the same negative behaviors next time.
The Bottom Line
It may seem random at times, but human behavior is remarkably predictable. This predictability often boils down to our preexisting biases, which can be very destructive when applied to our investing.
Only through recognizing our own biases and working to overcome them will we become better investors. And if you’re not trying to get better, you’re guaranteed to get worse!
So be flexible, accept change, get prepared, and be the best investor you can be.