Economies are in a mess. Markets are in chaos. So whether you're
bullish or bearish, it's all the more important to keep a cool head and make
carefully considered, rational decisions.
The fact is, you probably don't. We all like to think that we
make decisions based on logic, but emotion and psychology inevitably affect our
thought processes. There's a large body of evidence from behavioural finance
studies that indicate both private and professional investors are prone to
psychological biases in their decision making. That leads to sub-optimal
performance at best, and disaster at worst.
I've listed the five most dangerous biases below. Just being
aware of these biases can improve your investment decision-making, but I've
also suggested some practical steps to reduce the risk of succumbing to them.
1. Availability Bias
Availability bias is the natural tendency
to give undue weight to more vivid or prominent facts. It's why we fear plane
crashes more than car crashes, even though the latter are statistically more of
a risk. I
In investment, availability bias frequently shows itself as an
over-reaction to news. It's bad to buy a share straight after reading a tip or
a relevant piece of news. Instead, it's good to thoroughly research a share and
reach a considered view, then to buy as the market -- itself showing
availability bias -- over-reacts to a piece of bad news.
2. Confirmation Bias
We don't just give more weight to recent facts, we also give
more weight to facts that support our pre-conceived opinions. That's confirmation
bias. While this psychological tendency no doubt helps politicians to sleep
at night, it wreaks havoc in investment, where reaching the right conclusion
matters more than how well you articulate your case.
The value of a share is a delicate balance between lots of
positive and negative factors, and the investor has to judge what weight to put
on eachine. To help address this bias, think hard about the negative points,
and be your own Devil.
3. Anchoring
Anchoring is the trait of being attached to a
particular piece of information, and then interpreting other information to fit
with it. In investing, the most obvious example is the market price: when we
value companies we more often rationalise the market price than determine value
from first principles.
Of course, the market price should reflect all the information
about a share as interpreted by all investors, so this price does have a real
meaning. But anchoring is dangerous when the price moves and your thinking
remains stuck to what the share was once worth.
4. Overconfidence
You're not overconfident, are you? Me neither. Modesty could be
my middle name -- except it sounds a trifle feminine. But I guess I'm not alone
here in striving to obtain better-than-average returns. The problem is, too
many of us think we can be above-average for us all to be right. A 2006 study
by James Montier found that three-quarters of fund managers believed they
achieved above-average returns. Montier's paper has a fascinating self-test to
reveal your own cognitive biases.
So overconfidence is a trait we all have to be wary of. It
manifests itself as being over-optimistic: seeing the potential upside more
than the downside risk. And it can lead to over-trading.
5. Loss Aversion
Psychological experiments have shown that people are more strongly
motivated to avoid losses than to make gains. In investing, it gives rise to
the disposition effect, which we have probably all felt: investors
are generally much more reluctant to sell shares at a loss than at a profit.
Logically and dispassionately, it should not make a difference
to the decision to sell when the price is either above or below what we paid.
In classical economics, losses are sunk costs. But there are a couple of
exceptions to that rule. Crystallising profits and losses can have a tax
effect. And there can be good reasons to sell winners, for example to maintain
the balance of a portfolio or if you anticipate the good times will soon be
over.
Four-Point Plan
Being aware of cognitive biases can help you avoid being
over-influenced by them. Otherwise, taking a disciplined approach to investment
is the best antidote.
I'm less disciplined than I mean to be, and that's less than I
ought to be. This is real life. But I have a four-point plan to make myself act
on cold logic:
·
Slow things down by always putting shares on a watch list before
deciding to buy;
·
Go through a check list to force yourself to think about all the
important factors;
·
Write down a brief investment thesis, with positive and negative
points, and;
·
Have a stop-loss price. Even if this doesn't automatically trigger
a sale, it should force you to revisit your investment thesis.
Do you have other techniques? Let us know in the comment boxes,
below.
![](http://l.yimg.com/bt/api/res/1.2/_GSE6I72RWQzVFVUPtzljw--/YXBwaWQ9eW5ld3M7cT04NTt3PTMxMA--/http://l.yimg.com/os/251/2012/05/21/MASONS-OLDEST-GRADUATE-08-jpg_161354.jpg "Bertie Gladwin, 91, said that he had "a lot of laughs" with students less than a third of his age. Image- Masons")
