Bias will make you poor and it will make you poor without you even knowing it. See, the human mind is programmed to respond in certain and specific ways to things like loss, change, lack of control, and the way we process information. Since humans are the primary decision makers of the markets, it’s very easy to see how bias can take advantage of your returns. This is a double edged sword though because understanding bias can lead you to become a better trader if you understand the reasons that other people buy and sell. Here are a few of the most important biases to look out for when you are making your own investment decisions. Ambiguity Effect
Sometimes we don’t have all of the puzzle pieces that we need in order to make a decision. Previously, humans had to take these pieces of information that we did have and form enough knowledge so that we could make decisions that would affect our survival. Over time, humanity had to change to accommodate those missing pieces of information while still making decisions. It did that by trying to reduce the amount of ambiguity in the risks that we take. One thing that we know about the market is that investors dislike uncertainty. This is because humans who are unsure of their outcomes will work very hard to be as safe as possible. The safest path that someone takes, the better they will feel. This is why investors move out of riskier assets during unpredictable periods and move towards safer assets when they believe that they understand how the market works. The same rule applies to confidence. Investors who are more confident in their ability to predict will move into riskier assets. The most important thing to work on is the ability to find which pieces of information that you are missing in order to make a comprehensive decision and find that information.
Another issue with humans is that we tend of over exaggerate the importance of events that happened more recently. I first began to understand this in college choir where I was taught to focus on the last half of the song because that was the part that people would remember and judge us on. This can manifest itself in many different ways, but one common situation that I’m sure we’ve all come across is investing in a company that has been doing very well for numerous quarters, and then suddenly earnings fall. We are more likely to believe that the company is doing poorly based on an individual event that may have changed your perception of the company.
Disposition Effect Bias
Sometimes investors will decide whether or not an investment is a success or a failure. This can manifest itself by causing an investor to hang onto an investment for longer than they should. If they believe that a company is a winner and they maintain that mindset, they are less likely to sell when they should. Conversely, if you label a company a loser and sell it too early before the quantitative evidence tells you to, then you will pay more capital gains tax than you should be.
This bias works by looking back at your previous decisions and seeing an obvious or clear pattern in the results that you are seeing today. For instance, if you have been watching a company go up in value, you may look back and say “of course this M&A deal was going to make the company more valuable” or “of course this product launch was going to make the company more revenue.” In reality, during those crucial decisions that the company was making, there is always the chance that the M&A deal would have fallen through, or that the product would have been a flop.
Investors are more likely to experience and feel loss than they are a gain. If you offer someone a 50/50 shot of either losing $10 or gaining $10, people will often not take the bet. This is interesting because in terms of decision-making models, the bet it completely arbitrary and the “dollar value” of your choices are exactly the same. This means that investors are more likely to sell out of their investments after a particularly tough week, even when long-term growth prospects are still good for the company. Interesting, some investors are also subject to regret aversion bias, where they will hold onto a company believing that it will come back even when prospects are slim because they do not want to recognize the fact that they have made a poor decision. Cough Cough VRX Cough.
All of these biases also play a role in many other areas of our work and our personal lives. It’s a tough thing to grapple with, but once you recognize them you are much more likely to make better investment decisions and hopefully realize greater gains. Good luck on keeping your mind in check!