Last Updated on 12 July 2021 by Dan
Hello everyone! I thought an interesting topic to discuss today would be to look at the more psychological side of investing, and some mental traps and elements of bias that nearly everyone experiences at some point.
One of the reasons it’s really difficult to invest well is the fact your brain literally tries to trick you in the way that it processes information. We’re hard wired to condition ourselves towards things that activate our rewards centres and release serotonin into our brains for a “job well done” but are much less good at engaging with the real issues when something has gone a bit wrong.
This has issues both for risk management and getting the most out of our investments – if we’re not seeing the full picture it becomes very easy to make wrong decisions.
I find behavioural economics a really fascinating field which lots of these elements of bias are rooted in. We all like to feel we’re fairly rational and sensible individuals but when you look below the hood I suspect most people (including myself) will recognise they’ve been guilty of most or all of these at some point!
The secret to success here is simply to be aware of these “distortions” and to consciously and calmly check in if you feel they may be the case. Today we look at some of the most common ones:
Loss Aversion Bias
Loss aversion is closely tied to that idea of the activation of reward centres in the brain I mentioned earlier.
Let’s take two investments in two shares:
Share A I sell at a profit. Woohoo! Big kick of serotonin!
Share B I hold, but it’s making a loss at the moment. I think: “That’s no good, I believed in this – maybe it’ll turn to profit in the long run. Man, I don’t want to take a loss, then it’s real”.
The point here is that the urge to avoid that loss, because it feels like you’re accepting a position of failure.
Continuing to hold the share could be the right or the wrong option – the point is that we shouldn’t just “hold and hope” because we hope our wrong result might turn into a right one.
Instead it’s time to calmly challenge that analysis, see what’s changed and if you missed something. Is the stock still a good long term prospect, or is it time to cut your losses and move on?
We shouldn’t see selling at a loss as always a bad thing – because sometimes it’s protecting you for selling at a bigger loss because you just couldn’t let go.
Mental Accounting Bias
This is really a direct follow on from the above, and feeds off exactly the same set of mental bias where we want to perceive ourselves as winners.
A mental accounting bias is where when mentally talking to someone else about how our portfolio is doing we speak about the “instagrammed and airbrushed version” rather than the truth – enthusiastically raving about the good days when things are up, but being much less likely to discuss the bad days when things are down.
It’s one of the reasons part of our philosophy as a site is that you should only invest in companies you believe in for the very long term. The market moves up and down, and sometimes it’s not connected to the company itself. A long term view means you simply don’t worry about the drops.
Now this one has many applications beyond just investing, and the internet in particular is awash with it!
Confirmation bias feeds off our tendency to make immediate snap judgements on something. We see a situation, and immediately have an intuitive sense of what the answer might be.
The brain does this as part of protecting us, and in simple situations it’s very useful to know what to do quickly. The problem is we also apply this to complex economic and political scenarios.
Confirmation bias comes when we reach that initial conclusion but instead of actively trying to justify it, we over-focus on pieces of information which support our initial theory. We therefore become increasingly convinced our view of the world is correct, and information that shows a different conclusion is wrong or not relevant.
In terms of how we apply this to investing it’s during the analysis phase – where we think something appears to have a good case to be a buy or a sell, and how the due diligence takes place when following through.
This is an example of a “look-back” bias, where we look at a decision we made in the past though the lens of the information we know today.
Let’s take a situation where we made a loss on a stock. An example of hindsight bias might be that the share price was unexpectedly hit by a market event, and we tell ourselves that we should have seen the market event coming, and blame ourselves for that.
However that isn’t the real learning opportunity here – we may not have been reasonably able to identify the market event at the time and actually, we’re not looking at if that external event hadn’t happened if we did the right thing or not.
This one therefore simply causes you to focus on the wrong things when looking back – and you simply need to think about what’s important.
One of the most innate and fundamental human emotions is that we like to be liked, and we have a certain bias towards liking those most similar to us.
Whilst debating a topic might be good for you, your brain’s pleasure centres are much more stimulated by complaining about how everyone else is wrong with someone who agrees with you!
This really flows through to meetings with other people. When you look at studies into this area, is really quite terrifying how quickly groupthink takes hold – the more some people in the room reach a conclusion and state what they’re for, the perception of “social cost” to be against it goes up. It leads to a bias towards the outcome being the first conclusion that was reached by a member of the group, rather than the right conclusion.
This one is much more cultural, and often requires consciously either getting the group to agree to actively review decisions without judgement, or getting someone to play “Devil’s Advocate” to advocate a rival position and only making a decision after. The irony is that when active challenge is there, you usually end up in a much better position.
Interesting fact: Completely unrelated to investing, but did you know that the term “Devil’s Advocate” comes from an individual who is chosen and required to make an argument against someone becoming a Saint when it’s up for debate?
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This isn’t a full list of all the different types of bias out there (they’re actually shockingly numerous) but I think it covers some of the main interesting ones. I’m interested to hear if you’ve picked up any elements of bias in your own investing process and how you’ve managed it.
If that’s you, or you have another good one to raise just let us know by leaving a comment below!