June 20, 2024

Five Behavioral Biases To Avoid in Investing

Authored by Rahul Setty

While picking successful stocks is supremely important in driving investment results, more important in an investor's journey is the ability to know themselves and avoid significantly negative outcomes that dissuade them from permanent capital losses. In that lens, I am often reminded of the famous Mark Twain quote:  “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.“

With that said, let us proceed to a discussion of numerous deleterious behavioral biases that must be actively countered, as well as examples of each in the bullet points below.

1. Confirmation Bias

Confirmation bias means actively searching for information that confirms existing beliefs or preconceived notions. Any potential skepticism is capitulated, and information agreeing with a certain stance on a given topic is paraded around as fact.

"In fact, believing is so easy, and perhaps so inevitable, that it may be more like involuntary comprehension than it is like rational assessment." -Thinking in Bets, by Annie Duke

  • An investor regards their long position as smart because the stock is going up.
  • An investor curates their social media feed to receive news from others who already agree with their stances.
  • Ambiguous or questionable data is interpreted as highly positive.
  • Lack of attention given to base rates, focusing only on the sparse successful outcomes of a cohort.
2. Overconfidence Bias

Overconfidence bias is overestimating one's ability in ascertaining the future and is often accompanied by hubris in positioning.

  • An investor believes the market will decline significantly in the short term based on technical analysis or macroeconomic data, and positions a significant amount of their portfolio within out-of-the-money put options that are statistically likely to expire worthless.
  • An investor has researched an undiscovered company they believe is undervalued, but misses a key detail about competitive differentiation which reveals itself within the next earnings report.
3. Loss Aversion

Loss aversion reflects the pain associated with losses being greater than the pleasure of gains, assuming the two are of an equal amount. Loss aversion is one of the greatest mistakes an investor can make, as the success of a winning investment can make up for an underperformer many times over. Winners tend to continue to win, and the right-tail of the bell curve is where the vast majority of the market's growth is derived. This is inherently a reflection of power laws and Pareto's principle.

  • An investor has 100% gain on a stock, where they have reason to believe the company will continue to perform exceptionally well. The investor does not want to lose the gain, and thus sells the stock. In-line with the investor's original thought process, the stock continues to outperform significantly.
  • An investor does not want to realize a loss on a losing investment, thus the loss aversion often results in larger losses from refusing to sell (driven by a desire to sell at breakeven).
  • Citing circle of competence, an investor refuses to invest in high-growth businesses as the associated share prices have recently increased at a rapid pace, increasing potential odds of losses. The key here is loss aversion driving the decision making resulting in avoiding all risk (which is just as risky!). Despite citing circle of competence this is often the secondary or tertiary reason.
4. Herding

Herding is when individuals refuse to think for themselves, simply mirroring behavior of those around them. Such behavior leads to bubbles and excessive stock valuations in both directions. This can create countercyclical opportunity in quality businesses, though the fallout from euphoric highs is likely to cut sharply in the other direction.

  • Dot-com bubble (late 1990s and early 2000s)
  • ZIRP-mania (2020-2021) and subsequent bear market (mid-late 2022 and early 2023)
  • Short squeezes on meme stocks such as Gamestop, AMC, and Bed, Bath, & Beyond
  • Cryptocurrency bubble
  • NFT bubble
  • 3D Printing bubble
  • Cannabis bubble
5. Anchoring Bias

A market participant anchors to the first piece of information or price they have on a given security.

  • A stock performs well and rises consistently. The free cash flow multiple and growth rate is identical to what it has been historically, but an individual refuses to buy since the stock is higher than when originally discovered and misses out on alpha.
  • Anchoring to prior highs: an investor will not sell until a stock returns to prior highs, irrespective of opportunity cost or business/management quality.
  • An investor buys a stock due to a bullish analyst price target, but when execution becomes subpar, continues to anchor to the original analyst target when the investment case has changed. By the time the analyst revises a price target downwards, the stock is trading for significantly less.
Concluding Thoughts

In this author's eyes, the biggest risk to an investor not achieving long-term success in the market is falling victim to their own behavioral biases. The reason why most investors underperform the index is because they are incapable of holding it. Fearing losses, they sell only to watch the market continue to move higher most of the time, and either overconfidently crowd back in at much higher levels or anchor to their sale price and 'lock themselves out' of the stock market, proclaiming the entire system as a massive farce. By recognizing the biases within themselves, investors can proactively understand their blind spots and work to eliminate the effect these pitfalls can have on their portfolios.

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