Co-authored with Beyond Saving
I’ve always been intrigued by the psychology of investing. Today, I want to talk about biases. A bias is a strong tendency to act in a certain way or to interpret something in a certain way. Two people given the same information might come to different conclusions and therefore different actions. Is the glass half empty or half full? Your answer to that question will exhibit a bias.
With investing, every transaction involves two people making an opposite investment decision. One is buying, and the other is selling. One wants more of the stock, the other wants less.
When managing our portfolio, we want to make “the best” decisions. Which isn’t really possible because none of us can see the future. However, we can try to at least make good decisions. Our efforts to make good decisions will be impacted by numerous biases that we have.
Let’s look at seven biases that are very common among investors, and might be costing you money.
1. Anchoring Bias
“Anchoring” bias is a tendency to rely too heavily on the first piece of information you receive on a topic. We commonly see advertisements that take advantage of anchoring bias by showing a high price, anchoring our expectation of what the price is, but then offering a “sale”.
In the market, this bias works in several ways.
An investor might have a good or bad perception of an investment based on a past experience. If we invested in a company and later sold at a loss, we might label it a “bad” investment and refuse to consider it in the future, even if conditions changed in a way that fixed whatever issues caused the prior underperformance. On the other hand, we might become particularly attached to a company that has provided a positive experience in the past. This could make us willing to overlook warning signs and poor current performance that seems so obvious to an external observer.
Of course, we do want to take the past into account. What we want to avoid is situations where our past experiences are clouding our assessment of the company currently.
2. Recency Bias
Where anchoring bias is putting too much weight on the first information we get about an investment, recency bias is putting too much weight on what happened recently.
Consider these two investments, here are their 5-year returns. Based on this information alone, which one would you buy and why?
Investment A:
Investment B:
A very large number of investors that I know would choose Investment A. Indeed, many of the investments I write about regularly have 5-year charts that look more like Investment B, and on most days I get some form of the question: “Why would anyone buy Investment B? Its 5-year chart is horrible and has underperformed Investment A.”
What is Investment B? It is the S&P 500 ETF (SPY), the same investment as Investment A. The only difference is two months. Investment A is SPY from January 2015 through January 2020. Investment B is SPY from March 2015 through March 2020. Two months difference led to a 45% lower CAGR.
Recency bias is so pervasive among investors because the very tools we use to measure what is a “good” or “bad” investment are inherently biased. A large change in price over the last month or two will have an outsized impact on the 1-year, 5-year, and sometimes even 10-year returns.
We tend to look at the most recent price, and believe that it is “right”. I hear investors all the time proclaim that a certain investment decision was “good” or “bad” based on what the price is right now, without any analyses of value aside from the current trading price.
Another way that recency bias can impact us is making us believe that a stock is “cheap” just because it is down from recent highs, or believe that a stock is “expensive” because it is higher than recent lows. In both cases, we are making an assessment of the value of a stock based on recent trading prices, rather than any kind of attempt to identify the value of an investment to us.
As investors, we should always keep our eyes on the big picture. Avoid being influenced by short-term price movements.
3. Confirmation Bias
Confirmation bias is focusing on information that supports your existing beliefs. We are more prone to read opinions from people that we usually agree with. If we are bullish on a stock, we will more eagerly accept the arguments of others who are bullish, while dismissing the arguments of those who disagree without serious thought.
As investors, we should welcome arguments that are different than our own. We should do our best to seriously consider them, and question whether we might be wrong. It is, perhaps, one of the hardest things to do.
4. Exaggerated Expectation
A form of confirmation bias, exaggerated expectation is a tendency to expect that an extreme result is more likely than it really is. Like many biases, this is a bias that cuts two ways. When a stock price is falling, there will always be a chorus of investors insisting that it is likely to “go to zero”, even when an assessment of the financials concludes that is very unlikely. On the other hand, more than one stock has seen its price fly to unreasonable highs, and many investors project future valuations that would be unlikely even with extreme outperformance. Remember “Meme” stocks?
We must have realistic expectations for our portfolios and our stocks if we are going to make sound investment decisions. Having an exaggerated expectation could cause us to sell at poor prices, fearing a downside that simply isn’t likely to happen. Or it could cause us to overpay for an investment expecting an upside that could very well be impossible.
