Cognitive Biases in Investment.
How to use the knowledge of Investor Biases to improve your portfolio.
Behavioral biases in Finance do have a big impact on the various investment decisions that investors make. More often than not, do impede their success. There are several investment biases that have seen investments earn less than the market benchmark. While they are not solely to blame for poor earnings, they are responsible for the avoidable mistakes that keep on happening in the market to this day. Investors aim to maximize financial returns while minimizing the underlying risks. This is what a rational investor would do each and every time, but investors are rarely rational. They are influenced by several biases, which although they are aware of them, just can’t seem to overcome their influence.
Efficient market hypothesis posits that the prevailing stock prices reflect all the available information on that stock. This theory is only valid when the markets are efficient, and makes it impossible to perform better than the market. This is never the case though, as investors are irrational, not all investors utilize information uniformly, as there are a lot of market anomalies.
In this article, we are going to look at how knowledge of these biases impedes successful investment strategies, and how to counter them in order to come up with better strategies. With examples, we are going to demonstrate how knowledge of these biases and heuristics can be used to identify good investment opportunities.
Below are just some of the biases and how to counter them. Keep in mind more biases exist.
Investors tend to feel the pain of loss much more than they feel the pleasure of an equal amount of profit. A one dollar loss is much more painful than a one dollar profit is pleasurable. This is a major motivation for investors and how they strategize all their investment decisions. This bias affects both the risk takers and those that are risk averse, and creates an irrational behavior amongst investors.
An example of this is when investors offload their stocks once the price slightly goes up, with the fear that it might drop soon. This happens even when their analysis tells them to hold on to the stocks for a while longer and realize much more profit. Another effect on investment strategies is that investors tend to hold on their stocks for way too long, even when the market is bearish and the stocks are trading in less than the buying price. Investors are of the view that the stocks are not making losses until they are sold, so they will hold on to them, which is an irrational behavior. Investors also tend to only have guaranteed investments with low returns in their portfolio, and tend to stay off stocks with a higher risk and higher return potential.
Investors tend to be overconfident in stocks that they should offload due to their poor performance, and will ignore the analysis telling them to cut their losses. Pride and feat will override sound technical and fundamental analysis.
An example of a loss aversion in the stock market happened in 2018, which saw a couple of market corrections. The average investor performed poorly, losing twice as much as the S&P 500 index. This poor performance was largely due to investors’ loss aversion, where investors offloaded their stocks early as they feared they would lose much more. When the market corrected itself and rebounded, they all missed out on the potential gains. Analysis would have told them to hold on to the stock as the market was due to a correction, but their loss aversion bias overrode it.
How to Avoid Loss Aversion
One way to counter this bias is by ignoring the original cost of an instrument. What should matter for a stock are the instrument prospects and the prevailing market value. This way, investment decisions will be made based on the performance of the stock and not the fear of losing the original cost.
Another sound strategy to help is to always seek a second opinion from someone who isn’t as emotionally invested in a portfolio as you are, as they will give you an objective analysis.
Coming up with a rationale for an investment does help with this bias, where before you make a decision, you see if the rationale holds or not. If the rationale holds, you still hold on to the stock, and when it no longer does, you offload it.
One of the rational could be value investing. Before adding a stock to a portfolio, an investor should look for stocks that are currently trading at a lower price than their intrinsic value. A detailed fundamental analysis should be carried out on stocks that are under consideration, and decision based on that analysis. This way, the irrational fear of loss can be avoided by depending on the analysis, and until the intrinsic value is realized, the stock should remain in the portfolio.
The effects of herd behavior were heavily witnessed during the 2007–2008 financial crises, when majority of investors wanted to offload their stocks at the same time. Herd behavior in Finance is a situation where investors succumb to social pressure and leads them to follow the decision of others. Investors in this case abandon their own analysis and assume that the crowd knows better than they do, and end up following the investment decisions that the majority make. Emotion, fear of loss and instincts override rationality in investment decisions.
Many companies, especially the dot com companies when they were starting out, did not have sound business models. A rational investor would do a proper analysis of their stocks and uncover this, but what happened was that they gained hype, and many bought their stocks because others were doing so. We are hardwired to follow the crowed, as psychologists have found empirical evidence that going against the crowd. If for example people are buying Apple stock en masse, if you decide to offload the stock, it will cause you and your client physical pain.
We desire companionship, and that’s no different in investment. We seek safety in numbers, but that means abandoning sound analysis. There are several ways to take advantage of this bias and come up with great investment strategies, with strategies like contrarian investment discussed below.
Contrarian investment is a type of investment which bases itself on seeking out unrecognized risks and opportunities amid the herd investments. During the frenzy of herd investment, a lot of analysis is ignored in favor of the prevailing wave. A contrarian investor can find a niche of investment by going against herd investment, and use that to greatly improve the performance of their portfolio.
Many investors do not prioritize financial market analysis, and they are more concerned with community, family and their career. This lack of market acumen exposes a lot of opportunities that are ignored by most investors when they follow the herd. A contrarian investor then has a lot of opportunity to do detailed analysis and explore them.
A contrarian investor tends to enter the market when the herd is having a negative view of a stock. At this time, this investor seeks out stocks that are trading at a lower price than their intrinsic value. When the herd is chasing the hot stocks, they tend to overprice them, and the distressed stocks in turn tend to be underestimated. The upward movement of the hot stocks is limited, and they tend to have a steep fall when the market corrects. This is where the opportunity that the herd can’t see lies, as a contrarian investor can then buy up those stocks that are trading below their intrinsic value. This strategy can ensure a better performance of the portfolio. Contrarian investors tend to buy when the market is performing poorly, and tend to also hold their stock for a longer term, making the short term volatility almost negligible.
There are thousands of stocks to choose from in a major market, but we aren’t wired to have sufficient attention for all of them. For this reason, investors are limited by their attention span, and this brings about a bias, where the stocks that get their attention. There are, at any particular time, better performing stocks, but most investors won’t get to know about them.
If a particular stock gets media attention, or is mentioned by a friend, an average investor will pay more attention to that stock, and will tend to hang on to it longer while ignoring other opportunities. Overconfidence bias comes in here; where the investor assumes he knows better than the other investors because of the attention they accord the stock. This leads to the investor making less than ideal, risky investments.
One way to take advantage of this bias as an investor is to avoid relying on media or referrals for your investment decisions. When a stock catches your attention, take time to analyze it objectively before adding a stock to a portfolio. Take time to research stocks that don’t get media attention and expand their perspectives.
There are several other biases that affect the way investors pick their stocks. They include:
- Confirmation Bias
- Information Bias
- Oversimplification Bias
- Restraint Bias
- Anchor Bias
- Self Serving Bias
- Narrative Fallacy
- Hindsight Bias
An investor should also acknowledge their biases when developing a portfolio, and then go over the portfolio again with that acknowledgement. This will help them see the stocks for their value and prospects, and not through influence of their inherent biases.
I might be writing on the above biases soon, be on the lookout.