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Beating the biases that can stop you profiting from the market

Wednesday, March 15, 2017 9:44
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(Before It's News)

ISA season and the new tax year are as good a time as any for a spot of portfolio spring cleaning. But in making the decisions to add new positions and cut back others, there are potential pitfalls to be aware of. Billions of years of evolution have wired humans to think and act in certain ways – but they’re not always well suited to the stock market.

Psychologists have identified hundreds of cognitive errors and emotional biases at work in the human mind. For the most part, they fall into two categories:

  1. Cognitive pitfalls that lead us into defective reasoning.
  2. Emotions (like loss aversion and overconfidence) that lead to bad decision making.

The good news about the first group is having them pointed out is apparently often enough to overcome them. With that in mind, there’s a subset of those pitfalls that are of particular interest to investors. They fall under the banner of Belief Perseverance, or cognitive dissonance.

One look at the phrase Belief Perseverance will probably have some investors nodding knowingly. These are the subtle cognitive errors that lead us to cling on to beliefs, opinions and convictions even in the face of overwhelming evidence to the contrary – and they can be costly.

Let’s have a closer look…

1. Confirmation bias

We’ve covered it before, but Confirmation bias is a big challenge for investors. After making a decision, it leads individuals to gravitate to information and opinion that agrees with what they already think. In simple terms, there’s a risk of falling in love with a stock and losing all objectivity about it.

With easy access to vast amounts of information and discussion on the internet, it’s never been easier to seek out and find confirming views. With broker research becoming more increasingly accessible, it’s equally possible to find comfort in the words of favourable analysts. But these too are prone to cognitive errors (see Conservatism bias next).

The associated risks are huge. Confirmation bias can create a false sense of confidence and a willingness to join herds of other besotted investors who are seduced by a story. Contrarian investment strategies (such as those used by David Dreman) have been created to take advantage of those suffering from Confirmation bias, so avoiding it is essential.

2. Conservatism bias

Conservatism bias is when individuals prioritise their original beliefs and expectations even if new information shows they should change their minds. This is a problem that’s often linked with analysts but it applies to investors, too.

Like Confirmation bias, Conservatism bias puts the investor (and analyst) at risk of under-reacting to new and perhaps more accurate information. This lagging reaction is known to be a cause of price momentum, which other, more rational investors can take advantage of. (Stockopedia covers a range of Momentum strategies that are based on just this type of investor behaviour).

James Montier, a respected equity strategist and behavioural finance expert, believes Conservatism is often caused by something called the ‘sunk cost’ fallacy. This is where decisions are heavily influenced by what an individual has already done or invested, rather than being rational and objective.

As such, it’s a bias that could conceivably lead to investment decisions like ‘averaging down’ on a losing share or buying more shares in a holding that’s just issued a profit warning. It might turn out to be the right call, but statistically – particularly in the case of a profit warning – it won’t be.

In The Little Book of Behavioral Investing, Montier explains: “This is a tendency to allow past unrecoverable expenses to inform current decisions. Brutally put, we tend to hang onto our views too long simply because we spent time and effort coming up with those views in the first place.”

3. Hindsight bias

Hindsight bias is what happens when an individual feels that they knew an event was going to happen before it did, even though there’s no justification for it. Psychologists have shown that surprising events tend to reframe all our previous thinking and the big risk is that we become overconfident in predicting the future (because we “knew-it-all-along”).

One expert on this is the renowned psychologist Daniel Kahneman. In his book, Thinking Fast and Slow, he explained that the core of the Hindsight bias illusion is that we believe we understand the past, which implies that the future should be knowable. But in fact, we understand the past less than we think we do.

In his book Contrarian Investment Strategies, US fund manager David Dreman makes the point that Hindsight bias significantly limits what can be learned from experience. He wrote: “As a result, we think mistakes are easy to see and are confident we won’t make them again – until we do.”

4. Illusion of Control

If Hindsight bias is all about overestimating our ability to predict past events, take that a step further and you get Illusion of Control. This is about overestimating our ability to control the present.

Some psychologists have suggested that this human mind quirk is driven by a desire to avoid uncertainty. Rather than following the advice to “don’t just do something, sit there”, actively tinkering with a portfolio gives the Illusion of Control. It’s credited for a range of damaging investing habits, including overconfidence and costly over-trading.

In James Montier’s words, Illusion of Control seems most likely to occur when lots of choices are available; when you have early success at the task; the task you are undertaking is familiar to you; the amount of information is high and you have a personal involvement. In other words, precisely the condition that you’re like to encounter when investing.

5. Representativeness

Finally, Representativeness is a tendency to take new information and force it to fit with an idea or a narrative that we’ve already formed in our own mind. Falling for this can make it difficult to accurately assess new information – like financial results or stock price movements – and be objective about it.

Research shows, for example, that investors buying investment funds suffer from representativeness by believing that recent performance is overly representative of a fund’s future prospects. In other words, they predominantly chase past performance and are unrealistically optimistic about the odds that fund performance will continue.

In his book, Investment Blunders, behavioural finance academic John Nofsinger says that representativeness can cause investors to buy stocks that represent the qualities they desire.

He wrote: “One quality investors prefer is an increase in the stock’s price. Because of the representative bias, investors expect an increase in a stock’s price after witnessing the price increase in the past. That is, people tend to project the previous trend into the future.”

Beating the bias

In their book, Superforecasting, Philip Tetlock and Dan Gardner noted that ‘beliefs are hypotheses to be tested, not treasures to be protected’. That neatly sums up the view of many psychologists when it comes to avoiding the Belief Perseverance pitfalls that can undo investors. Simply being aware of these challenges is part-way to overcoming them, but behavioural scientists do offer more practical avoidance tips too. Here are a few ideas:

  • Constantly challenge assumptions about a stock
  • Keep a trading journal of investment decisions and reasoning
  • Play devil’s advocate with investment ideas
  • Listen to people that disagree
  • Seek out contrary views and evidence that an investment case has changed
  • Be objective

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Source: http://www.stockopedia.com/content/beating-the-biases-that-can-stop-you-profiting-from-the-market-175683/

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