I think behavorial finance is a very important topic for an investor (and in other walks of life too) and one should spend some time learning about and trying to avoid the common psychological pitfalls. I discussed some of these pitfalls in the previous posts (here and here).
Some good books/ resources on the topic are listed below
Seeing what others don’t : The remarkable ways we gain insight
Lets explore a few more baises and how one can avoid them
Sunk cost fallacy – This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted, then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.
I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.
Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.
It is however dangerous to get seduced by a story stock or company. Unfortunately you can find investors buying into stories all the time and overpaying for it. The stories change, but the basic theme is always the same. A new or exciting development comes to the attention of a few investors (IT stocks, real estate stocks or consumption stocks). These smart investors have the insight of investing early at attractive valuations. This ‘story’ is soon picked up by the media and now others follow blindly into the story at astronomical valuations. The ‘story’ feeds on itself and everyone looks good as long as the price is rising. At some point investors start realizing that the valuations are too optimistic and the selling begins. The ‘story’ is discredited and investors wonder how they got sucked into it
How does one avoid getting sucked in? There is one word for it – valuations. Never overpay for stocks, no matter what the story. If something is obvious to everyone, then the price reflects it and it is ‘overconfidence and hubris’ on part of most investors to assume that they are smarter than the market.
Base rate neglect
If you ask someone an unpleasant question – are you more likely to die in an airplane crash or heart attack, what is the more likely answer? I can bet in the majority of the cases, it would be the airplane crash (heart attacks are a more common cause). An airplane crash is more vivid and comes on the front page of a newspaper, whereas heart attack deaths are almost never publicized.
Almost everyone tends to neglect the base rate – statistical probability of an event. Investors tend to do the same. Let’s consider some examples – 90% + options expire worthless and various studies have shown that IPOs tend to underperform market over the long run. Inspite of these statistics, investors believe they can do better, mostly because they are not even aware of the low success rates.
How does one take advantage of base rates? One needs to focus on areas where the odds favor you. It is far easier to do well with companies and industries where the underlying business has a high rate of return. In such cases, unless one pays too much, the investor is likely to do well over time.
In summary, know where you have an advantage and work on exploiting it. For example – I know for a fact that I cannot beat a full time trader in the short term and hence I will never invest in a stock or option where the odds are stacked against me.
Over optimism and overconfidence
One needs a level of optimism or confidence to do well in life. At the same time, there is fine line between confidence and over confidence. How do you know you have crossed it?
If you find yourself, attributing all the success to your intelligence and failure to bad luck and other factors, you may be crossing the line. As an investor, if your performance is not above average (after several years) and you still think that there is nothing wrong with your approach and think that it will all work itself out, then you need to dial down your confidence and optimism.
What about me? I have had the reverse problem – I have always been underconfident and that has been harmful too. I have underallocated to equities in the past and created smaller positions in my top ideas. As a result, my opportunity loss has been far higher than my actual losses.
In my case, the actual results have given me the confidence to be more aggressive, though I still finding myself doubting all the time.
No silver bullets
We have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.
The first step in overcoming these biases is to recognize them and acknowledge that we are often influenced by them. The next step is often to build routines to reduce their impact or negate them completely. Some shortcuts I try to use
– Do not look at the stock price when analyzing a company to avoid getting ‘anchored’ by the stock price
– Never buy a stock which is hitting upper or lower circuits. There is a lot of emotion around the stock/company and it is better to let the dust settle down, before one can analyze the situation calmly and make a balanced decision
– Try to look for at least three reasons which could cause the idea to fail
– Do a probabilistic analysis of the stock, to evaluate the downside. How low can the price drop?
– Avoid IPO, options and current fads
– Never listen to tips – especially from TV. If it is recommended on TV, everyone and his uncle knows about the company and the price already reflects the prospects.
– Analyze the stock from a 2-3 year perspective where I have a strength over the other short term players in the market.
– Don’t tell about your losses to your wife. She will think that you are smarter than you really are 🙂