In Part 1, we explained how to deal with some of the most common psychological pitfalls that investors encounter. We left some of the more insidious for last:
Overconfidence: We tend to overestimate our own abilities – our confidence in our predictions is generally greater than their accuracy.
Solution: Actively consider the counter arguments to your predictions and, when investing, always leave a margin of safety between the price you pay and the value of the asset to allow for mistakes.
Status quo bias: Where we tend to prefer the current state of affairs and resist change.
Solution: Overactive trading isn’t a good idea, but so too is blindly sticking with your current portfolio or asset allocation. Don’t get attached to individual stocks – focus on your opportunity cost to hold them (is there a more undervalued opportunity you are forgoing?)
Information bias: The tendency to keep seeking more information, even if the extra information is irrelevant to the decision.
Solution: When making an investment, it’s common to think ‘I’ll just wait to see what happens, then I’ll invest’. Learn to be comfortable with incomplete knowledge and focus on the key issues – there will always be something else you want to know.
Risk compensation: Our tendency to increase the amount of risk we take when perceived safety increases. For example, motorists tend to drive faster when they are wearing seat belts.
Solution: When stock markets have risen for a long period of time, we feel good and safe – be wary of increasing your exposure to stocks, concentrating your portfolio in fewer investments, or making more speculative purchases.
Anchoring: Our tendency for decisions to be skewed by sometimes irrelevant information that was learned earlier. This bias tends to creep up when considering an appropriate share price at which to buy or sell. We are often anchored to last month’s share price or our original purchase price.
Solution: Hard as it is, forget yesterday’s share price and your purchase price – the only thing that matters is where the current share price stands relative to the stock’s intrinsic value.
Recency bias: Our tendency to remember and overweight conditions and information that is most recent. When investing, this bias often results in inaccurate projections that assume current conditions will continue far into the future.
Solution: The importance of looking at long-term performance and long-term averages for a given data set cannot be overstated. A stock’s intrinsic value is a function of all the cash it will throw off between now and forever. A lot can happen in that time – today’s newspaper headlines are unlikely to matter much in the big picture.
Naïve diversification: We tend to focus on the number of things in our portfolio, rather than their individual qualities.
Solution: Simply owning more stocks and funds doesn’t mean you are well diversified. Take a moment to think about your individual holdings and whether they are in the same industry or exposed to similar threats. Good diversification is about reducing risks, not adding stocks.
Social proof and referencing: Our tendency to copy the actions of those around us. When we become uncertain of how to act or what to think, we often mistakenly assume that those around us know what’s going on better than we do and so follow their lead.
Solution: A decision isn’t right or wrong merely because many people believe it. Ignore the crowd and focus on your own research or finding trusted advisors. The stock everyone is talking about is unlikely to be the most undervalued.
Commitment/consistency bias: Once we have committed to an idea or investment, we tend to want to remain consistent with that decision. For example, if you have verbally proclaimed the attributes of a certain stock to friends, you’re less likely to change your mind.
Solution: In general, the less you talk about your portfolio with others, the easier it will be for you to change your mind about its contents. Discussing investment ideas is important, and fun, but watch out for defensiveness creeping in. ‘A man who has committed a mistake and doesn’t correct it is committing another mistake’ – Confucius