As the market is going a bit sideways after a mild earnings season, we are entering the famous “sell in May and go away” period, I thought of revisiting some investment biases we all experience at one point or another.
When I did my financial classes, everything seemed so well calculated and rational. Financial theories are so simple, so easy to understand, it’s impossible to mess up the application in the real world, right? Investors are rational individuals making sound decisions based on facts and just calculations…. Well this is what is being written in many financial books anyways!
Unfortunately, the truth is rather more complex. Emotions taint our judgment and have us do things that don’t really make sense. Since it is very hard to control our emotions, I thought it would be interesting to read about certain investment biases so it could ring a bell when such a situation occurs. At least, you will have the reflex of taking pause and to take a second look at a specific situation before pulling the trigger.
Over-Optimistic Bias
Once we make a purchase, we become more confident this was the right decision and that this company will provide a higher returns. However, the company’s situation didn’t change between the moment we analyzed the stock and made a purchase. However, our brain will tell us that this company is better once it is a part of our portfolio!
Scientific researchers have proven similar behaviors within the gambling industry where the team chosen becomes better in the gambler’s mind once he made his bet.
Confirmation Makes us Stronger
When we believe in something; we tend to give it more credibility and more weight to data, research and opinions confirming our belief. On the other hand, we tend to ignore or diminish the value of research and opinions going against our beliefs. This is because we like to find people that think like us and disregard people who challengeg our thoughts.
For example; if I find that Apple (AAPL) is an amazing company, I will give more value to Carl Icahn telling the world this stock should be traded over $200 instead of another investor explaining why AAPL is at risk.
Consensus Bias
If most investors in your environment agree that Johnson & Johnson (JNJ) is a great dividend stock and should be part of pretty much any dividend portfolio, it is hard to go against the crowd. The truth is, JNJ might not be such an amazing stock, but it “becomes one” since everybody is going in the same direction. Funny enough, we see that bias even with professionals!
Loss Aversion
This one is well known; it hurts more to lose $10,000 than it feels good to make $10,000. Go figure why, we are that kind of animal!
Price History
Many investors consider the price they bought as guide for the value of a stock. For example, if I bought RIM (now BBRY) at $65 (yes… I did that when I was younger) and the stock is now trading at $10 today, I could hold on to it thinking it will go back to its original value. As if the fact that RIM once worth $65 means that it will always worth that price in the future.
Fortunately, I sold it when it was around $45 and kissed it goodbye. Many investors hold on it since the stock was once worth over $200 and it has to go back… somehow.
Engagement
If we spend several hours and invested a big chunk of our nest egg in an investment, we tend to be more lenient and patient with it. We consider the energy and money invested and refuse to admit we did it for nothing. This is why people sometimes keep losers in their portfolio for a long time simply because they invested too much in it to acknowledge the loss.
Immediate Rewards
As funny as it is, losing hurts more than you can have pleasure winning, immediate rewards seem more important than long term success. Therefore, investors will tend to find the “cheap stock that will bounce back” quickly instead of buying a sound company that will grow slowly but surely over time.
Personally, I have divided my portfolio into two sections to manage this bias. I have a small portion of my portfolio invested in the hope of making immediate rewards (investment horizon of 18-24 months) and the rest is invested according to making money over the long haul.
Which Bias is Your Worst Enemy?
Throughout my 13 years as an investor, I’ve experienced many biases. Fortunately, I solved most of them and I’m able to make more rational choices. However, I still struggle to consider opinions going against my beliefs. I tend to ignore those articles or read them briefly thinking the writer is wrong and I’m right. However, no one is always right; therefore, reading opinions that question your beliefs daily is probably the best remedy for this bias!
What about you? What biases your investing decision?
Hey Dividend Guy,
Great post buddy. I can relate in one way or another to each of these biases. I find the ones that ring true the most are: price history, loss aversion and consensus. It’s hard not to have an interest in companies that everyone is buying – but people have to be certain that the reason one person bought the company is in line with your goals and desired metrics as well. Everyone must do their own research before purchasing!
Thanks for this and opening my eyes to a bit more of the emotional side of investing which is ever so apparent and crunching down on A LOT of investors and not in the best way.
Best regards,
DB
Hello DB,
thx!
Most people hate losing money and holding on to the price history makes them feel better as “they know it will come back”.
It’s a good topic to speak about during a family party 😉
Cheers,
Mike
This is a nice summary behind different types of biases. I find it funny how investors tend to go around in clusters, seeking comfort when others agree with them. For example gold bugs read only gold bugs, index investors read only index investors etc. If someone comes and challenges them, they get unhappy and attack them.
I have found that the best way to overcome biases is to have a plan, and then use factual data to make investment decisions. An investor who has no plan, will end up jumping from strategy to strategy, and never really amounting to much. Another important lesson is to keep learning about investing – other strategies, market history etc.
You are right; having a plan is a “stupid proof” strategy against investing biases. Each time I feel emotions growing, I go back to my investing plan and stick to it!
DivGuy,
Fun article/read. I know I have an Akron based company in my portfolio and more than likely should rid my position, but it’s not a “bad company” by any means, just more of – I think there may be a stock to replace this one. I don’t sell because of the city where I was born and raised feel – talk about bias there.
I agree – it’s funny to see the whole “I bought it at $20 because it was ONCE worth $50, it has to be worth that again… at some point, right?!” haha…
-Lanny
Fun idea for a post Mike. My bias, or honestly WEAKNESS, is being too conservative. I know you never go broke taking profits, but I chickened out of two investments in the last 6 years……either of which would have set me up to retire by 30. I don’t mean work part time…..I mean DONE.
That being said, just because I missed a few back then doesn’t mean I should take undue risks now.
-Bryan