Most of the time we’re not aware of it, but our investment decisions can become highly influenced by cognitive biases which can lead to terrible mistakes. These biases can lead people to look for shortcuts, try to oversimplify complex decisions or information and act on an overconfident manner as a result of overstating their abilities/knowledge.
One way to look at it is that they can act as optical illusions for our perception, therefore changing the way we interpret information and the conclusions we draw from it.
Therefore as investors, it is essential that we find ways to identify these biases and minimize their influence on our decisions.
By the time you finish reading this post you will understand cognitive biases and how to protect yourself from them, leading to better decision making which will hopefully translate into higher investment returns.
Commitment Bias
As we all know it, doing proper research on a business can take a lot of time. Reading annual and quarterly reports, earnings call, earnings presentations, reading articles related to the business, watching interviews, etc.
Now imagine doing all this work and finally come to the conclusion that the business does not represent a good investment opportunity (perhaps the business model isn’t resilient enough or management doesn’t seem trustworthy).
If we are not careful, commitment bias can cause us to try to ignore the negatives behind this company in order to come to conclusion that the company is worthy of our capital. We’ll begin looking for ways to rationalize all the information in order to make us feel like all those hours of research did not go to waste by reaching a buying decision.
Perhaps you’ll even ignore facts like:
The company being overleveraged.
Lack of growth opportunities.
Competitive advantages are non-existent.
Just so that you can justify making your research “valuable” or worth it.
So, what can you do to combat this?
The main way you can combat this cognitive bias is by changing your goals/incentives.
In the beginning of my journey I fell victim to this bias. I did all this research, read tons of information and watched many videos related to the business and I “forced myself” to buy the company’s shares in order to feel like all that effort was worth it in the end, because I felt that if I didn’t buy it all the research I did would have been pointless.
Even when we all know that our end goal is to find outstanding investment opportunities, we should look for ways to remove the frustration of not accomplishing this feat whenever we finish our analysis, and find ways to feel like our analysis was valuable even if it doesn’t lead us to a buying decision.
What personally worked for me is using content creation and my desire to learn. Now, whenever I finish researching a company, whether I end up considering it a viable investment vehicle or not, I know at the end I’ll be able to share my analysis (either through twitter or Substack) with other people and exchange ideas and perhaps they’ll find it useful or valuable.
And on the learning side, whether I decide to invest or not, in the end I would have learned a lot about a business sector, perhaps I learned about another industry in the process which may present an interesting opportunity, or maybe I learned something along the way which will improve my future analyses.
Therefore my goals behind my current analyses are a) To make the best possible research and write the best article I can reflecting my assessment of the business. (as far as my writing skills allow me to) and b) Learn as much as possible along the way.
By being these two my main goals, and finding good investment opportunities being only a consequence of trying to accomplish these feats, I can now avoid having my judgment be clouded by any type of commitment bias.
Note: This is what has worked for me personally, I acknowledge most people may not wish to become content creators, but I do believe that finding ways to make your research worth it even when it doesn’t lead to a buying decision can eventually lead to better investment decisions.
Overconfidence Bias
This one is pretty self-explanatory. Overconfidence Bias arises whenever someone has a false sense of their skill/talent/knowledge and tends to overestimate them.
Whenever an investor begins overestimating his abilities, and begins to act like he can accurately predict the direction of the economy, interest rates and the stock market, that’s when big loses arise.
Therefore the best defense we can put in place to protect ourselves from overconfidence is adopting an essential characteristic of successful investors, which is humility. We must acknowledge our limitations and put our highest priority on avoiding losses, not on executing bold strategies.
Confirmation Bias
Confirmation bias refers to the natural human tendency to focus on information that confirms our current beliefs/ideas/conclusions. This can be very dangerous for investors since it can give raise to overconfidence because they feel they keep getting data that appears to confirm their current conclusions, leading to poor decision making.
In order to protect ourselves from this cognitive bias, we must always remain open and seek information that causes us to question our investment ideas and perhaps even completely contradict them. We should also continually revisit our past conclusions and deeply analyze why we might be wrong rather than why we are right.
You can also try to build devil’s advocate cases against your thesis or ask someone else to do it. This can make sure you are keeping in mind all possible risks and are not ignoring any important information just because it contradicts your current thesis.
Endowment Effect
The endowment effect arises whenever we place a higher value on something simply because we own it. (If we didn’t own it we would consider it less valuable)
Investors must be careful not to “fall in love” with their holdings and always keep in mind the existence of opportunity cost. If fundamentals have been constantly deteriorating we must have the willingness to exit a position even if that means incurring a loss.
Incentive-caused bias
This cognitive bias makes emphasis on the power that rewards and incentives can have on human behavior and their decisions.
Perhaps this bias most important functionality is to apply it externally. For example, when analyzing the management of a business take a look at their salaries and whether they own relevant stakes in the company, this way we can incur if their interests are aligned with those of shareholders or not.
We can also apply this to money managers, where by analyzing their fee structure we can also incur whether they are running the fund to the benefit of investors, or if their goal is to simply amass Assets Under Management in order to collect fees.
“Never, ever, think about something else when you should be thinking about the power of incentives.”
-Charlie Munger
Oversimplification tendency
Whenever we try to understand something, we are always seeking to obtain a clear and simple explanation. However, there are matters that are inherently complex or uncertain which don’t lend themselves to be further simplified.
As investors, we should seek to stay within our circle of competence and avoid trying to oversimplify information in order to justify an investment decision. For example, if you can’t understand the complexity behind a financial institution or a biotechnology company, the most intelligent decision you can make is to simply walk away.
“Make things as simple as possible, but no more simple.”
-Albert Einstein
Hindsight bias
Hindsight bias arises whenever people convince themselves after an event has happened that they could have accurately predicted it or perhaps even going to the point of saying “it was obvious”.
Most people who fall in the trap of this bias begin feeling too confident, and make them think they can predict the next market movement or economic development, which in almost all cases ends up leading to disasters.
Bandwagon effect or Herd Mentality
The bandwagon effect arises whenever we gain comfort in our decisions or ideas when we see many people make the same decision or hold the same belief.
One of the worst things an investor can do is following the herd (most of the time done blindly), causing them to buy during bubbles or sell during panics.
It is important that we become able to analyze, think and come to conclusions independently.
“We’re happiest when we’re not part of the herd; we prefer to watch the herd’s extreme boom-bust behavior and profit from its mistakes. Most other investors seem to be happy when they’re part of the herd and following the trend.”
-Howard Marks
Anchoring bias
Anchoring bias is a psychological tendency to rely too heavily to, or anchor to, a past reference or piece of information when making a decision.
In the investing world a common anchor is the recent share price and recent price movements, where if there’s a drop relative to recent prices people assume the company is now cheap or vice versa, completely ignoring any relevant valuation metric.
“A huge decline doesn't necessarily create bargains if preceded by a huge advance.”
-Howard Marks
We must avoid basing our decisions on recent prices or past price movements and instead focus our attention on the intrinsic value of a business and whether we can acquire it below that price by requiring an adequate margin of safety.
Sunk cost fallacy
The sunk cost fallacy effect arises whenever an individual refuses to abandon a strategy or course of action (in this case, an investment) because they invested heavily into it, even when it is clear that abandonment is the most beneficial alternative.
Although it may be very hard in the first few times, we must not hesitate to accept whenever the fact that we’ve made a mistake in our assessment of a business becomes clear (not because of stock price movement but because of fundamental developments).
Don’t get discouraged, such losses are our best teachers in order to become better investors.
TL.DR:
Commitment Bias.
Overconfidence Bias.
Confirmation Bias.
Endowment Effect.
Incentive-caused Bias.
Oversimplification Tendency.
Hindsight Bias.
Bandwagon Effect.
Anchoring Effect.
Sunk Cost Fallacy.
As investors the best defense we can build is to have systems and processes in place that minimize the number of mistakes we might make due to our cognitive biases. One of my favorite tools in this regard is the use of checklists.
There are many cognitive biases (a lot) out there which can influence our investment decisions, and I skipped a lot in this article in order to avoid it being too long, but I thought I would cover the ones I considered the most important.
If you want me to expand on these I could make a continuation on a second post at a future date. If you have other cognitive biases or psychological tendencies which you consider relevant, please let me know in the comments.
And that’s all from me today!
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Excellent read my friend, I love the topic!