Eight biases you should be careful of underestimating

The efficient market hypothesis assumes that all humans are rational and act in their own self-interest. However, humans are often irrational and self-destructing, through no fault of their own other than being human. By being aware of these eight biases, we can actively prevent them from harming our financial health.

Anchoring bias

Our purchase price often lends us to place an emotional anchor at that exact price. Whilst natural, many of us can be lulled into making sub-standard decisions because of the anchoring bias, for example, many of us will know the feeling of waiting for the price to reach our breakeven price before selling, only to see the stock reach within a few pence of it and drop back, leaving us wishing we had sold.

Another danger of the anchoring bias is in technical analysis. Whilst technical analysis does help investors spot key levels on the chart, it can lure us into placing too much emphasis on the levels and act not in accordance with our investment thesis.

When we buy a stock, we have done so because we believe the current valuation offers upside and that it trades at a discount to its real value – by looking at resistance points on the charts we become tempted to sell and try to buy in cheaper. We may get lucky a few times doing this but often all we do is sabotage our investments. Unless the goal is to trade, technical analysis doesn’t always mix well with fundamental research.

To combat the anchoring bias, we should ignore the price we paid for our shares and always focus on the current price. Would we buy the stock now at its current price if we did not own it? If yes, then great; keep holding. But if the answer is no – you know what to do.

Endowment bias

The endowment bias is very similar to the anchoring bias, in that both focus on the purchase price, but the endowment bias differs in that we believe that the shares we own are better by the virtue of us owning them! This is, of course, nonsense, but we see it all the time in the housing market. Houses will often be priced well above the street’s average for sale price despite the house itself being unremarkable, yet the owners are convinced that their house should be priced higher than most of the houses in the street.

Like the stock market, the housing market often finds its equilibrium point, and the overpricing is often ironed out as sellers revise their sale price downwards, but unlike the housing market the endowment bias in the stock market can be potentially costly. Holding onto stocks we should be selling, or holding onto the sector laggard despite evidence showing there are more attractive stocks in the sector, can damage our portfolios.

The classic example of the endowment effect was in a study from Kahnemann, Knetsch & Thaler, who gave participants a mug and measured the willingness to accept versus the willingness to pay of those who had not received the mug. They found that ownership of the mug demanded compensation almost double what new buyers were prepared to pay.

Information bias

We are constantly bombarded with new information on a daily basis, be it from the news, social media, bulletin boards, and even the company’s own Twitter feed. So, your investment has won a new contract? That’s good news, but if it was material and meant anything it would have been put out in an RNS announcement. The fact that it was not clearly just means that it is business as usual, and therefore offers us nothing that would either bolster or cause us to change our investment thesis.

The problem we have as investors is that there is so much noise. Financial commentators cannot just say that the news does not matter, because then they’ would have nothing to talk about! So, instead, they come up with reasons for why the FTSE has ‘soared’ 2pc that day, or why the Dow has ‘plunged’ 1pc. Unfortunately, these financial commentators can never tell us before the event, so that we might be able to place a trade and make money, but they certainly don’t have any problems telling us why what happened came to happen.

These shows and columns again seduce investors into making spur-of-the-moment decisions based on emotions, when history has shown us that we are probably best leaving our investments alone, unless we are given a strong reason to sell.

Daily share price movements are of no interest to the long-term investor and as the saying goes – “those who stare at the tape all day will be sure to end up feeding it”.

To avoid the information bias, we should switch off the noise and conduct frequent check-ups on our investments, but only to ensure nothing has gone wrong.

Recency bias

The tendency to overweight the importance of a piece of news in the context of the overall story is the recency bias. We do this by easily remembering something that has occurred now or recently, compared to being able to recall or even place the same importance on an event that may have happened a while back.

The problem here is that we may take small and trivial events and place more emphasis on those than an important event. A good example would be believing that the company winning a contract is a good sign, yet disregarding or even forgetting the profit warning a few weeks ago.

A good method to beat the recency bias is to collect our thoughts and important events in a single place, that way when another piece of the investment puzzle is released, we can weigh it up and place it into context of the overall puzzle.

Loss aversion

The act of avoiding loss is one us humans are prone to naturally. We are much more likely to cut our winners (in order to massage our ego that we were right) and be risk averse whereas with losers we will be risk seeking and run the loser, or add to it, perhaps even when the investment case is deteriorating.

Kahnemann and Taversky (1979) found that the pain of losing an amount is psychologically far greater, about twice as powerful, as winning the same amount. This explains why the free trial is so effective – it plays on the feeling of loss. It is also why penalties are far more motivating than rewards. Try it next time you need to motivate yourself, and you’ll see just how strong the feeling is.

To defeat loss aversion, we need to constantly train our brain to do what is unnatural. Going with the herd was once what was safe, and trusting your instincts got us out of danger of predators quickly, but in the investing world there are no place for such emotions.

Holding onto losers in the hope that they will eventually come good is psychologically draining. Knowing what can kill our investment thesis and constantly being on guard looking out for that catalyst will save us plenty of both physical and psychological capital.

Restraint bias

This bias is the tendency for people to overestimate their ability to control themselves and resist impulsive investment decisions. Almost all of us think that we shouldn’t commit large portions of our capital to a single stock lest we put ourselves at risk financially, but all of us will know the feeling when we find a certain stock that we’re so sure it’s a winner, and we’re tempted to steam in with a large position.

The beauty of small and mid cap stocks is that if management do execute then there is plenty of upside. Rather than going all in at the start where the reward is highest (and also the risk), we should buy in small and add to our position once management begin to prove themselves. There is no rush and this allows us to follow the story objectively and let the investment case build strength and derisk itself.

Gambler’s fallacy

The gambler’s fallacy is very similar to the Hot Hand fallacy – believing that previous investments have a connection to them. This happens when one believes that because they’d had five losers in a row, they’re now ‘due’ a winner. Unfortunately, the reality is that all events are interdependent of each other – even when trading in the same stock.

The market doesn’t care how many losers you’ve had, and the market doesn’t take into account a ‘hot hand’ either, which is when one believes that after a string of winning positions or trades that they’re on a ‘streak’.

Be aware that when we are at our most confident, that is when we are at our most vulnerable. The market will be ready to humble us in a big way should our egos get too big. Icarus, after all, flew far too close to the sun.

Sunk cost bias

Sunk cost is the notion of believing that after investing, we must continue to invest because we have already invested. To protect against sunk cost, we must ask ourselves if we would buy that same stock as the price it is now, if we didn’t hold it.

Sunk cost has been used to explain the endowment effect, but another effect of the sunk cost bias is that it prevents funds from being used elsewhere. Chasing a loser may mean missing out on a big winner!

The opportunity cost can be far in excess of the sunk costs already deployed, and though it can never be calculated, it only takes one big winner that we miss because we were laden with something we didn’t much want to hammer that point home.

Rounding up

To recap, here is a summary of the eight biases.

• Anchoring bias – ignore the price we paid for our shares
• Endowment bias – recognise that we are inherently placing a value higher than the market by the single virtue of us owning the stock
• Information bias – be careful of market noise as it can lure us into action
• Recency bias – collect information and clearly write down the investment case
• Loss aversion – remember that every big loss started as a small loss; have a plan for when we are getting out
• Restraint bias – instead of going in large at the start buy small and allow management to prove their worth to you
• Gambler’s fallacy – the market doesn’t care about previous actions; previous actions are not linked
• Sunk cost bias – we don’t need to be right, and if we wouldn’t buy at the current price if we didn’t own the stock, then we should think about cutting the loss

Author Michael Taylor’s website www.shiftingshares.com contains numerous tutorials on how to trade and invest as well as his free book – ‘How to Make Six Figures in Stocks’.

This article originally appeared on https://www.valuethemarkets.com/2019/10/11/the-shifting-shares-view-eight-biases-that-investors-should-be-wary-of-part-2/