5 mistakes and how to avoid them:
- Confirmation bias
- The endowment effect
- Loss aversion
- Outcome bias
Thinking is exhausting work. The brain devours between a fifth and a quarter of the energy used by the entire human body, despite accounting for just 2 to 3 per cent of overall weight. Little wonder it has developed a plethora of short-cuts that enable us to make fast-and-easy decisions that are often very effective.
However, these sort-cuts are so seductively effortless that we often use them to make decisions that would be much better as a product of slow-and-effortful consideration. Listed below are five aspects of human nature that can prove costly for investors.
Mistake #1: OVERCONFIDENCE
Evidence of our overconfidence is everywhere: from frequent underestimates on the cost of high-profile infrastructure projects, to surveys that consistently show the vast majority of people consider themselves better than average at anything ranging from driving skill to moral character.
Michael Mauboussin, author, finance professor and head of consilient research at Morgan Stanley Counterpoint Global, suggests it is useful to break overconfidence into three key areas: “overestimation” of one's own abilities; “overplacement” of how good oneself is compared with others; and “overprecision” based on belief in our own ability to answer difficult questions (and sometimes unanswerable ones!). He considers the third issue as being most problematic when it comes to investing.
Our biggest mistakes tend to occur when we are most confident. This is a particular issue in our information-rich age as confidence tends to grow the more information we have at our disposal. That’s despite the fact that there is often little relationship between accumulation of information and the quality of the decisions people make.
Another dimension of overconfidence is that we tend to require very little evidence to accept new ideas. The problems associated with this particular trait are compounded by the difficulties we have in rejecting ideas once we've accepted them, as we’ll find out next.
Take the rough with the smooth: Overconfidence encourages people to pursue ventures that can be hugely beneficial but have the odds are against them (famously 9 out 10 startups fail, for example). This trait helps us bounce back from failure, too.
Mistake # 2: CONFIRMATION BIAS
It is human nature to look for facts that support and confirm what we already believe while ignoring or explaining away anything contradictory. In 2009, the American Psychological Association assessed 91 studies into this phenomenon covering 300 independent groups and 8,000 participants. It found people were more than twice as likely to favour information that confirmed their view than went against it.
Confirmation bias also extends to the company we keep. An innate desire to surround ourselves with people who think like us is a key contributor to the often disastrous phenomenon known as 'groupthink'. Social networking sites can contribute to this issue.
Confirmation bias is particularly insidious when precise cause and effect are very hard to understand, as is the case with investing. Under these circumstances facts are altogether more malleable and can easily be corralled to suit a preferred argument.
Take the rough with the smooth: Confirmation bias helps us quickly assimilate new beliefs into our thinking which makes us quicker to benefit from learned wisdom and new discoveries.
Mistake #3: THE ENDOWMENT EFFECT
The endowment effect describes our tendency to put more value on things when we own them. This has major implications for investors making decisions to buy or sell. In particular, it suggests investors are prone to fall in love with certain investments and hang on to them for too long.
Research consultancy Essentia Analytics has found that the performance of many investments by professionals resembles a “reverse horse-shoe”; big gains early on that are subsequently given back over the lifetime of an investment due to reticence to sell. Fund managers could create 1.2 percentage points of outperformance by selling their positions following a typical six-month “window of opportunity”.
Take the rough with the smooth: This trait encourages us to protect and take care of the things we own and are responsible for.
Mistake #4: LOSS AVERSION
Another one of the most costly fund manager mistakes identified by Essentia’s research relates to loss aversion. There is a tendency to hold on to losing positions for too long in the hope the investment will rebound so that a loss does not have to be crystalised. More often than not, the rebound does not happen and the sale eventually happens at the bottom.
One of the many hugely influential findings by behavioural psychology pioneers Daniel Kahneman and long-time collaborator Amos Tversky is that the pain people feel from a loss is around twice the pleasure experienced from an equivalent gain. This has many implications for investors as they try to balance risk and reward.
Some of the biggest investment dangers associated with fear of loss come at times of financial stress. Indeed, rather than selling high and buying low, our emotional response to loss means we’re programmed to do the exact opposite.
Take the rough with the smooth: This trait keeps us out of a lot of trouble.
Mistake #5: OUTCOME BIAS
The stock market is particularly poor at providing feedback to investors due to the difficulty of disentangling the influence of luck and skill when assessing outcomes. This is a key reason why investors face such a major issues with outcome bias; our propensity to judge the quality of a decision based on its results rather than the quality of thought at the time the decision was made.
The problems of providing oneself with honest assessments on decision quality are compounded by the similar but distinct issue of hindsight bias; judging a decision based on information that was not known at the time.
Outcome bias, the roll of luck, and the long time frames often involved in investing, all mean feedback on investment decisions tends to be very poor despite the financial results being very tangible. Coupled with overconfidence, this means investors that keep getting lucky can misidentify skill in a flawed investment process right up until a calamitous day of reckoning. Equally, investors with a good process can give up on it due to a poor run of luck.
Take the rough with the smooth: In a world full of uncertainties, it is very useful to be able to draw a quick clear conclusion from an outcome rather than spend a lifetime pondering.