Biases in Action, or How to Lose Money Efficiently
Over the past year and a half, I’ve become interested in (obsessed with?) logical biases, fallacies, and mental models — what Charlie Munger calls the “Psychology of Human Misjudgement” (here’s a great speech about it he gave on at Harvard in 1995). And I have found a helpful exercise for me to better understand how biases affect my own judgement is to revisit and analyze situations where my decisions have been affected by them, and how could I have mitigated their effects.
A quintessential resource for helping me understand these biases is a book by Dr. Daniel Kahneman, Thinking Fast and Slow (I also have additional books and resources below). Drawing upon research that he and his partner, Dr. Amos Tvaersky conducted, along with similar research, he does a great job of describing how the brain works, and discusses these biases in depth, the causes of them, and how, if possible, to avoid them.
Biases are often difficult to see in the moment, but hindsight lays bare my flawed thinking in so many instances. So today I’m writing about an example from a few years back that demonstrates how powerful and pervasive (and hidden) they can be. The ones I’ve listed are in no way comprehensive — there are countless other ways I was affected through this, but these are some of the big ones.
Before we get into the story, here’s an explanation of some of the big biases. There are many more at play that I plan to talk about in future posts.
Overconfidence — excess confidence in one’s own abilities. We tend to think we are better than average at many things — but most people think they’re better than average…see the flaw?
Anchoring — we rely too heavily on the first piece of information (known as the “anchor”) when making a decision
Loss Aversion — it hurts a lot more to lose money than the pleasure you feel from a gain of the same amount
Confirmation bias — we selectively look for and consider information that confirms our belief. We also disregard evidence that doesn’t support our belief.
So, without further ado…
Risk Free, Fast Money.
A few years back, I was convinced that 3D printing was going to see explosive growth in short order, and that investing in it was a risk-free way to get rich. So, I began looking for ways to invest.
At the time, I knew nothing of valuing a stock — aside from Price/Earning (which hovered between sky high and nothing…they were investing in growth, right?) — nothing of discounted cash flow valuation, EBIDTA multiples, or anything else. And little did I realize that even if, as the Quartz article predicted, the 3D printing (or officially known as “Additive Manufacturing”) market did triple in five years (it didn’t, but it got close), the stock price already had those expectations built into it.
I conducted “extensive” investigation (which meant reading an article or two on investment sites authored by, at best, an investor who was slightly less ignorant than me, or at worst, a jackal trying to manipulate patsies like me) — and I quickly found a promising candidate in which to invest : a company named Stratasys (SSYS) — around $100 at the time. Everything that I read said they were the dominant leader in the 3D printing industry and had a lot of room to grow. It was clear that this was the company for me. Somehow I believed I was the only one smart enough to stumble upon this company.
I had a financial advisor at the time during the summer of 2013 and I asked them about Stratasys — to which they responded that it was overvalued and recommended against it. They felt that Apple was a better investment.
“they [Morningstar] have the fair value at $68 and it’s almost $40 over. Could it go higher? Maybe…” — my Financial Advisor
What Could Go Wrong?
I watched the price go from $50, then $100, then up to $130 — all while I missed out on the gains. And go figure, Apple took a dive. Of course I thought I was a genius. And I felt like I was smarter than my financial advisor. Or Morningstar. But I didn’t buy, and it hurt to miss out on the gains.
I ultimately decided to part ways with my financial advisor for various reasons like fees, etc — but I know part of me thought I could do a better job investing than them — pure and unadulterated overconfidence).
Finally, the price started to drop — a lot. I watched it go from the peak of $130 (my anchoring point) down to $36: a 72% discount! This was on clearance, and I decided it was time to buy. I disregarded a lot of good information that didn’t align with what I had already decided. I wanted to buy this stock — and I didn’t want to read something or be told I shouldn’t. Thanks, but no thanks, confirmation bias.
After I bought, I watched it like a hawk. I’d check the price multiple times a day — get sad when it went down, and get happy when it would go up (I was mostly sad). I watched it drop for a year and a half, still stinging each time I’d check the price as it went down, but watching it less as time went by, giving in to the fact that this was a losing investment.
I held on as it seemed to drop every day, but I’d have glimmers of hope that I might at least make my principal back. But it continued to drop. And finally, after going through a range of emotions, I sold it at $18 for a 50% loss. And it hurt. Bad. The pain that comes with loss aversion is significant.
How can you avoid making the same mistakes?
I wish I could say I did an immediate post-mortem on this and fixed all of my flawed thinking and bad decisions. But that’s not what happened.
Instead, I came upon some concepts about decision making theory, and starting reading all I could find out about it.
Can you avoid these biases? That’s a great question.
I’ve been meeting with some friends going through Thinking, Fast and Slow in depth — and we’ve been discussing the question at length of whether or not these biases be avoided, or at least minimized. The problem with most of these biases is that they are subtle and deceptive — and many times, right. So, our conclusion as to whether or not you can avoid them?
Maybe.
At a minimum, you can be aware that the biases can exist, but most times, you aren’t aware that they are affecting you. You can put processes and controls in place to help mitigate them. For example, you can form a mastermind group or peer work group or advisors where you can discuss important decisions. Ask them to take an opposing view, and have them help you analyze the decision and see where these biases might be affecting your judgement.
The moral of the story?
We can’t prevent our biases, it’s part of who we are and they affect every part of our lives. They influence your decisions, many times in positive ways, but not always. The key is being aware that they exist, and when you have important decision to make, take a step back and take some precautions to protect you from yourself.
More Resources:
Thinking, Fast and Slow by Daniel Kahneman
You Are Not So Smart by David McRaney
Influence: The Psychology of Persuasion by Dr. Robert Cialdini
