In my last blog, we looked into what kind of investor you are and slightly touched on some errors Link. Now it is time to see how our minds play with us and affect our decision making as well as look into judgment errors/biases. In investment management, there is traditional finance theory, which assumes that all individuals act rationally and is opposed by behaviour finance. As there is a large quantity of information available online around traditional finance and it is not very applicable in real life, we will spend most of the time talking about behavioural finance.
As you know life is not perfect, we will never be in a position where we know everything about the entity/investment or able to process all available information in the market. Our next subject is based on this idea.
Bounded rationality is looking into individuals decision making with incomplete information. When we start looking into stocks, we will need to make a huge amount of research to be comfortable with investment. However, eventually, we come to the point, where additional information does not help us to make a better investment decision, and it is entirely okay. So you have to satisfy yourself with what you have. Of course, if you feel that there is more fundamental information that needs to be researched, please, do so. Some examples could be that you have reviewed market, company fundamentals, and all directors. However, you cannot get information about inside changes in the business. If you are happy with your research and feel confident about the company’s future prospect, you can invest without knowing this additional info. The decision will not be optimal in traditional finance sense, but acceptable. You should make sure that the price is right as well and you leave some room for error, but we will speak in future blogs about stock selection.
Cognitive Errors and Emotional Biases
Now we know that information will never be perfect in our research. However, say we have managed to collect relatively complete info about investment and still at the end make stupid decisions. What else could stand between you and your “perfect” investment?!
The answer is in front of you, well if you look into the mirror! YOU. Or rather your brain/human phycology. It doesn’t mean that you are not able to make right decisions but your brains influence you without you knowing it. The next subjects will cover the most common biases that exist as a result of you looking into information and processing via your own way. It will be amazing and will blow your mind wide open. When I learned about these, I found various biases that applied to me. Was able to modify my own portfolio and make it more sensible.
Have a read and see if you can find few that apply to you!
Before we go into details, let’s group errors to make it easier to understand.
Cognitive errors – Result from processing information or your belief Perseverance. When we have information processing issues, we lack understanding of data analysis. If we take good information and end up misinterpreting, then this results in the incorrect conclusion. Please see examples below, where I talk about each bias separately.
Emotional Biases – As the name states, these are related to your personal emotions and experience. We all have a different background, which affects our understanding and arguments. Thus, our beliefs may have high weight on decision making and quite often relate with the expectation that the past will repeat itself in the future. Emotional Biases relate less with maths or information but more with how we frame it. Usually, reactions to investment are more spontaneous and unpredictable.
Cognitive errors: Belief Perseverance
Have you ever had an investment that you believed in with all your hard? However, new material information becomes available on the market, and you haven’t done much. This may mean that you have conservative beliefs.
Effect: You may be slow to adjust your portfolio or views. Could be the result of change stress or mental effort required to make a decision. The easier it is to make a decision, the more you likely to trade, the more difficult decision less likely you will take action in time.
What can you do?: Good news! You are already on track just by reading this blog. The first step is always the same for any problem, you need to realise you have this bias. You need to look into information impartially and decide what value it provides. If this material does provide relevant information, guess what, you need to use it and adjust your portfolio/fix bias.
So you have an investment idea or an “amazing” stock that you what to invest in. You go to the market and start looking for some evidence to why you need this investment. But Ups! You are looking just for information to validate your personal views. Why say “Yes” and not “No”. You may even try to take the high-quality information, which may say that you need to be careful and try to bend it to help your conclusion.
In a way, this is a selection bias. Say you made your first investment. Did all research, spend a month doing hard work before buying a stock. You actually become overly attached. As a result, end up looking information just to keep or buy this stock.
Effect: Of course, you concentrate just on positive information and ignore or dismiss negative. If you see just positive information, you may end up becoming too confident in your investment and overweight your portfolio with just a few assets. This will make your portfolio less diversified. Moreover, if you are overconfident in your investment, you may hold it for too long.
What can you do?: Well, you need to look for contradicting information, reasons to say “No”. If you cannot do this yourself find someone you trust, who can oppose your ideas. A friend interested in investment could help.
Please, raise hands who thought at some point in your life that the past will persist in the future. This is what this is based on. When you receive entirely new information, but interpret or explain info based on your past experience. Sometimes we cannot avoid, and it is an easy way to absorb new information. However, doesn’t mean this is always a right choice. This could result in your misunderstanding and partial resemblance to the past resulting in bias.
Two forms of representativeness include:
Base rate neglect – (Base rate = Probability) Basically, classification you give to some asset class is taken as being absolutely correct with no exceptions. Say you do research on Industrial stock and due to low P/E ratio and low P/B was initially classed as Value stock. When in reality, after further analysis the stock may not be a value stock and could have some growth stock properties, for example, high growth rate.
Sample-size neglect – It is exactly what it says. You would be ignoring some information or have a small sample of data. For example, you would like to invest in value stock, but take into account just low P/E ratio and do not take into account Div or P/B values.
Effect: You end up placing too much weight on given categories in the past. You could end up drastically changing your strategies on a small sample, which do not represent reality.
What can you do?: You need to consider both of issues base rate neglect and sample size. Review information and make sure that info given fits category allocated. You can use statistical analysis. However, you can resource to being reasonable.
Control bias (Illusion of control bias):
Here we need to admit something that is quite difficult to most of us. We cannot control everything! However, our brain miscalculates, and we quite frequently think that we are in control. This bias closely relates with emotional biases, which we will discuss later self-attribution and overconfidence.
Effect: Well if there is a belief that you are always right and have full control you will end up overtrading and have concentrated positions as you will have “one stock will make all the money” logic. Of course, overtrading will lead to higher trading cost and may eat up your potential profits.
What can you do?: You will need to get a friend or someone, who can advise you and will not be afraid to say when you are wrong. Also, you can track your trading and see if you actually have that perceived control.
Do you like remembering situations where you were right and forget all those times, when errors have been made? Then you might have this bias. You select what you like and not what is actually true. Say economy grew 3% and you say: “I knew it all along!”. Yeah easy to say post factum.
Effect: You expectation about asset performing might be overstated due to your selective memory.
What can you do?: When analysing assets to invest and future performance expectations, keep good notes, with all details. This will help you to have more objective views in the future.
Cognitive Errors: Information Processing
Anchoring and adjustment:
This is a lighter version of conservatism. Say you have received new information about the asset, but instead of evaluating new data independently, you try to adjust your initial valuation/believes. For example, you do not compute new asset value but try to increase or decrease the original. I am guilty of this bias as well. Do not anchor unnecessarily to the past.
Effect: Your decisions are not optimal as your valuation is biased to the previous value.
What can you do?: Well, you can ask a question. If you are keeping your asset because of past beliefs and not new updated information. You may be affected. You should then follow new information and possibly sell assets.
Mental accounting bias:
Have you ever received a bonus and treated it different from your wage, when considering investment decisions? Did you spend all your bonus on luxury products? Then metal accounting may be in your head.
Effect: You will end up structuring money (which is a neutral unit of currency) for various porpuses differently. Say money for the house could have a different value than money for the car. True, this would help you to stick to specific goals, but the result could be that your portfolio is not optimal/does not give highest possible value for given risk. Say you prefer spending money now. You would treat realised income differently from unrealized (assets you didn’t sell yet but would make money if you did it today). Let’s assume that the later has a higher return. Guess what!? You concentrated on income products because you wanted cash and did not consider about future, as a result, end up decreasing total potential portfolio value. And jeopardizing your key future goals.
What can you do?: Look into all your assets as part of your portfolio. Your house/car/cash as one and considers the correlation between all your assets. For example, if you have a house you should limit investment in homebuilders’ stocks.
Have you ever thought why you consider £1 value to be less when buying TV for £500 as compared with a cup of coffee? This works in investment as well. Say you purchased stock valued £5 and now it is £15. You are more likely to sell a stock and take £10 profit. But say your stock was valued £100, and now it is £110 you may end up waiting and risk losing as relatively £10 is less. But the result is still same £10 pounds.
Effect: You just concentrate on the small part of the information and not overall picture, which is that £10 is £10.
What can you do?: You should value things as expected return and risk rather just by computing returns from the initial value.
This is for those who end up going the easy way. Did you base your investment on the first magazine you have seen or some other readily available information? When considering easily accessible information, we should think about:
- Retrievability – Just picked up the information that is easy to access
- Categorization – You firmly believe that asset is a value stock. Thus, just look into P/E ratio, but ignore P/B because of your initial belief. You kind off thought it was pointless to check P/B as your view must be right.
- The narrow range of experience – Maybe you do not include some information because you have never consider/dealt with it in the past.
- Resonance – you believe that others will consider/interpret information the same way you do. Thus, buy a stock due to some info and hope that others will see the same way and stock price will skyrocket.
Effect: We may just select assets that you know. Thus, end up under diversifying. Also, you may choose potentially unsuitable asset allocation.
What can you do?: You should create IPS (Link) and a good record of your research. If you find yourself trading based on most reset news and do not do much research, you may be affected. Thus, you should consider what would sensible decision should be at that point and where further research is required.
You guessed it right. These biases come from your emotions and not conscious thoughts. This is quite difficult to adjust, and you really need to be self-conscious.
Loss aversion bias:
This is widespread emotional bias and very human like. Basically, you do not like losing more than gaining
Effect: List is quite long:
- You do get less joy from increase in price than from decrease in price
- You trying to avoid losses. Thus, you may sell winners too quickly and hold losers for too long. You say “Maybe the price will go up again!”
- By selling too quickly, you overtrade and your cost increase
- When you wait too long for losers, your portfolio becomes too risky as it has quite a few low performing assets as compared with well-performing assets portfolio (balanced portfolio)
- If you just bought stock and it dropped in value. You may end up taking an overly high risk, by holding and hoping for the price to recover.
- Because you value gains less, you are less afraid to risk it. You are treating it differently than any other capital. Thus, potentially deciding to take a too high risk.
There is a subcategory of loss aversion called Myopic loss aversion. You are afraid of losses so much, you will not trade stocks due to short-term risk, which is often present. Also, the definition of loss aversion is a fear of short-term decline. Out of interest lets,’s theorise a bit more, if most individuals have myopic loss aversion, investors do not buy stocks, then market stock values will be depressed and future profits more likely.
What can you do?: Follow predefined strategy and create IPS (Link)
This is closely linked with control bias. It is quite self-explanatory, but for the purpose of being complete, we will expand here as well. Biase is based on overestimating our ability to infare about the future or our reasoning. As before, you may think you have better knowledge than everyone else or attributing some outcomes to yourself, where in reality it could have been just luck! Confidence is good but should be balanced with proper research.
Effect: Think you are a big guy/girl and you end up underestimating risk you can take or your are too sure about a high return. Your personal portfolio may be overconcentrated. You may also end up trading too much, which would result in increased costs.
What can you do?: IPS (Link). Follow your long term goals and do not deviate without good reason.
Do you like spending money on that new watch or suit/dress? Well more you spend now, less you will have for investment and significant future goals
Effect: Your pension savings may be too small. When you realise you do not have enough funds for a reasonable retirement, you may end up taking an excessively high risk. Also, because you like spending money now, your portfolio may have more short-term income assets.
Whan can you do?: Plan, plan and plan again.
Status quo bias:
We do not like change here. If you feel comfortable with existing asset allocation, then you are less likely to change even if this is not an optimal decision.
Effect: Your risk may be exceedingly high, or you may not consider alternative investment options.
What can you do?: It is quite hard to overcome, and you need to investigate your risk/return profile as well as overconcentration of some assets.
Note: Other two biases are closely linked. The difference is that Status quo bias result in maintaining a choice due to inertia. Just too easy to stay put.
Things that you own have a higher value to you than the same thing in the market. It is an interesting phenomenon, but after today you will see it quite often.
Effect: You may not sell assets you have to in order to get an optimal portfolio. You will be holding just investments you are very comfortable with. Sometimes could be beneficial as you have good knowledge about an asset, but overall portfolio should be balanced.
What can you do?: Ask yourself what would you do with the asset if you wouldn’t own it and someone else did. Would you sell it?
Two things you can be afraid of. Making a decision or making no decision (action of commission and action of omission) may result in the wrong outcome. In general, this is the fear of making a decision.
Effect: Supper concentrated portfolio. Because you do not buy stocks as you know that they will underperform at some stage. You avoid the regret of losing money. When you do not invest in slightly riskier assets, your overall return might not be sufficient for future goals. You may end up making the same decision as everyone else. In a way, protecting yourself from a personal choice and you will not blame yourself when things go wrong.
What can you do?: IPS and consider your long-term goals and what it takes to reach them.
We have just reviewed most well-known individual biases and errors. You just become more conscious of your decision. Hope you can now better decide if your choices are rational or driven by a false understanding of information or emotional influence.