Since I’m eight, I’ve always been passionate by numbers. When I discover the world of finance, I knew exactly what I wanted to do in life: work around the financial market. I guess that one thing that captivates me is about how the stock market evolves over time. When you are at school, they teach us how the market is efficient and how it’s all a numbers game. Then, you get into the real life and you realise the market is driven by emotion. The worst part is that today, individual investors are not important enough to influence the market in a significant manner. The reality is that professional portfolio manager can get emotional too. As today’s market doesn’t seem to stop reaching new high each month I feel more investment bias comes into play. We now tend to “rationalize” our bias and find reason why the stock market will crash or will continue to rise for another five years. In both case, it seems that not much fact are put to work. We all know about common investor bias but we tend to forget about them when things go too well… or to bad. I decided to revisit the worst 2 investment bias in my opinion and found solutions to get around them.
#1 Confirmation Bias
This is a very behavioral bias that applies in all sphere of your life. The confirmation bias is the tendency of looking for information or people confirming what you already believe.
“Confirmation bias, also called confirmatory bias or myside bias, is the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses.” – Wikipedia
This totally makes sense. You would not hangout with people always telling you that you are wrong. Hanging out with people having the same mentality, beliefs will reinforce yours and makes you feel better. I rarely saw a vegetarian hanging out with several intense steakhouse fans.
The same bias happens all the time in the investing world. If an investor is convinced the market is going to crash, the only news he will read or give importance to are the one saying exactly the same thing. The financial market is a widely discussed topic across the internet and the media. For example, if you think Wal-Mart (WMT) is going to beat Amazon (AMZN), you will most likely find bloggers and analysts telling you that WMT is a strong dividend aristocrat and you will ignore my article on the topic.
How you can beat the confirmation bias
I think the best way to work around the confirmation bias is to play the devil’s advocate. I often find myself in a position where I’m getting very enthusiast about a specific company (I’m part of the optimist guys!). When this happens, I realise that I’m also looking at graphs and articles that will put this business above the others. After thinking I found a very interesting candidate for my new portfolio, I stop for a moment. I make sure I stop all my research and take a break. The idea is to take a break of all this “positive thinking” that is blinding a part of my brain. The next day, I look at the same financials but with a specific idea in mind: find the business flaw.
At this point of my analysis, I’m solely looking for the downside potential. What could go wrong? And there are always things that go wrong. By searching exclusively for negative analysis and challenging articles, I make sure I can find weaknesses in my first analysis. If the company pass the “negative” test at the end of this final round, I will consider buying it.
#2 Loss aversion Bias + choice paralysis
At the moment, I think this is probably the most powerful bias an investor is facing: the pain of losing money is greater than making some.
“In economics and decision theory, loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: it’s better to not lose $5 than to find $5.” – Wikipedia
As the market continues to reach new high month after month, investors are more and more concerned about losing their money in the market. They expect the market to crash any following day and rather wait on the side line and not making money. Because if you are about to invest $100,000, you rather earn $100 in the next month than losing $10,000.
Unfortunately, nobody knows about the future. Therefore, this kind of thinking is completely useless. The loss of aversion is often combined with choice paralysis. Choice paralysis comes when there is an overload of information. Which better topic than finance to find such kind of information overload, right?
How you can beat loss aversion
The pain of losing money or the fear of suffering such pain is a very hard bias one to get away from. The truth is if you are losing money, you will suffer! What could potentially save you from it is understanding that your short term paper losses will disappear over the long haul if you are well diversified.
Making additional research about long term investment planning should prove you that short term losses are part of the investing game. However, all academic papers will also prove that a well invested portfolio will perform well. In fact, the worst decision you can make when it’s time to invest is do nothing.
If you haven’t done it yet, build yourself a strong investment plan. You can inspire yourself from my 7 dividend growth investing principles as a starting point. With a solid plan in hand, it will be easier to follow the course and ignore the market noise when you start “losing money”. Don’t remember it is only paper money as long as you keep your shares. Dividend payments will help you wait and if the company continues to meet your investment thesis, it will go back up once the storm is over.
What’s your investor bias?
I’m curious to know about your investor bias? Mine is probably self-attribution (thinking that all success is linked to my own skills and work!)
Disclaimer: I hold AMZN, I sold WMT in 2016