Why do you buy or sell a share? For most investors, the answer seems obvious: its prospects and their personal circumstances. But the field of behavioural finance suggests that cognitive biases, or errors in thinking that all humans make, tend to play a powerful if hidden role in decisions on investing. Seven of the most common investor cognitive biases are as follows.
1. Loss aversion bias
"Humans hate loss; they avoid thinking about it and this is dangerous," says Tristan Chapple of Phoenix Asset Management, which runs Aurora Investment Trust (ARR), and for whom behavioural finance is a key part of the investment decision-making process. “Take, for example, where a company has a division that earns most of the profits and therefore drives the investment value. There is a tendency to only focus on that, even in companies that also have bad divisions that can detract value. Loss aversion bias causes investors to focus on the good bit and ignore the bad – until it's too late and the bad bit has rendered the investment void.”
Closely linked to our desire to avoid thinking about losses is the so-called disposition effect. This is the tendency of investors to sell shares that have increased, while keeping assets that have fallen in value.
Chris Dillow, Investor Chronicle’s economist, says: "People tend to hold on to their losing stocks in the hope that they will break even. They don't like admitting to themselves they were wrong. It's also why people will take profits on their winning stocks too soon, as we like to think we've got something right. But this is a nasty habit because there tends to be momentum in share prices. Running your losses exposes you more to downside risk, while cutting your winners means you are likely to lose out on any further gains."
2. Hindsight bias
It is much easier to know what to do after something has happened, and much easier to know which stock to buy after the share price has already rocketed. Predicting the future, however, is much harder. Nevertheless, as people we tend to fall into hindsight bias. This happens when, in our minds, past events seem to be more prominent than they appeared while they were occurring.
"When you look back at what's happened, you tell yourself a load of stories about why it has happened, which leads you to think the world is predictable and everything happens for a reason," says Mr Dillow. “If we tend to overestimate predictability, then we try to pick stocks on the basis of information that's not always relevant and trade too much.”
He thinks company growth is often more random than we like to think, but the hindsight bias leads us to oversimplify causes and effects. “Many investors think if a company has got a good management team then it will grow,” he explains. “And if the company doesn't grow, then they will come to the conclusion that the company's management can't have been good after all. It doesn't occur to them that sometimes even companies with good managers don't grow.”
3. Status quo bias
Status quo bias is when people think things will remain as they have been. It is also apparent when people stick with a decision they have previously made. This tendency can be particularly unhelpful when you have held a stock for a while.
"If you don't write down at the beginning what you expect will happen to a share after you invest in it, including key things like its profits and sales, and what its management may or may not do, then a few years down the line you're unlikely to have a very clear memory of the reason why you invested in it," says Mr Chapple. "And the chances are you've become acclimatised to the potentially new circumstances the company is facing and drifted from your original investment thesis."
4. Egocentric framing
This is the tendency to see problems and opportunities only from our own point of view, rather than put ourselves into others' shoes. This is a key pitfall for investors in all areas, but is particularly acute when it comes to investing in a company's initial public offering (IPO).
"While companies that have been launched at IPO might go up on the first day, research suggests they tend to do badly over a period during the next three years," argues Mr Dillow. "This is known as IPO underperformance and the reason this happens is because people tend to think of the business being launched as a great growth opportunity, so they buy. But they don't enquire as to why the people who know most about the stock are selling it. By not thinking about that, you're making a mistake."
5. Vividness bias
This is the tendency to overemphasise vivid examples of information and pay little attention to less attention-grabbing issues.
"Companies are very good at selecting what you see and what you don't see," explains Mr Chapple. "For example, they might present investors with a particularly vivid example and they will naturally tend to overweight that. A classic example would be a company like a retailer or restaurant group [making a projection of how it can grow its stores or restaurants].
"For example, a company with 100 branches in a certain format might announce that it has painted the walls a different colour and changed the menu at one branch, where there has been a 25 per cent increase in profits. The company might add that it can change all its existing restaurants and open another 100 branches. And often what financial analysts will model is that 25 per cent profit increase happening at 200 stores – an example of being disproportionally affected by one unrepresentative but vivid example.
"A more likely reason for that 25 per cent increase in profits could be that this branch is run by that company's best manager and is in the best location."
6. Curse of knowledge effect
While having knowledge of an area is often an advantage when investing, you also need to be aware that it can have downsides.
"For example, if an individual has spent a lifetime in engineering they will be less likely to be bamboozled when considering engineering investment opportunities," explains Mr Chapple. "But sometimes your knowledge means you bring a series of assumptions that can lead you to take mental shortcuts and make errors."
When retailer Sports Direct (SPD) launched its IPO in 2007 it did not report its like-for-like sales. This is a measure of sales growth widely used to indicate current trading performance. "But for Sports Direct it wasn't useful as the business was not being run in that way," says Mr Chapple. "When City investors asked the company what its like-for-like sales figures were, Sports Direct's management didn't have a ready answer and the City didn’t give them the benefit of the doubt. They just assumed any good retailer knows what its like-for-like sales figure is."
But Phoenix Asset Management asked Sports Direct how it ran its business and on the basis of that invested in it, and now the company is Aurora Investment Trust's third-largest holding.
7. Certainty bias
This bias refers to a preference most of us have for absolutes, as well as an inability to really understand the difference between different probabilities. Research by academics Amos Tversky and Daniel Kahneman illustrated this in an experiment. People were asked to choose between option A, which was a sure gain of $30 (£22.45), or option B, which was an 80 per cent chance of winning $45 and a 20 per cent chance of winning nothing. In the experiment, 78 per cent of participants chose option A while only 22 per cent chose option B, even though the expected value of option B ($45x0.8=$36) exceeded that of option A by 20 per cent.
“If I own an investment at £1 and my model tells me it’s worth £2, my likely error as a human is to put too much weight on the £2, which is only something I invented, albeit with some intelligent input,” adds Mr Chapple. “Much better to consider the possibility that the inputs in the model are likely to be at least partly wrong, meaning we should instead think in ranges, for example, the shares are worth between £1.80 and £2.20. This protects us from making mistakes when selling. If you are certain £2 is the right number, you are less likely to have taken some money off the table at £1.80. If you've used the range-based approach you would realise that it probably makes sense to reduce the weight of the investment at £1.80 because £2 might not be the right number.”
And many investors are overconfident. “We pretend to ourselves that we know more than we do and this means we tend to act when we shouldn't,” says Mr Dillow. “The market is inefficient, but that doesn't mean you're clever enough to discover where the inefficiencies are. The most successful investors – Warren Buffett and Terry Smith – spend most of their time doing nothing. They spend their time looking for good stocks but very often not finding them. What they don't do is spend their days trading.”
Protecting against yourself
As well as writing down what you expect to happen to a share when you first buy it, it is important to monitor whether your investment thesis still holds as time passes. Phoenix Asset Management uses a tactic it calls the "devil's advocate process" to guard against loss aversion and status quo bias. Every three years it evaluates every holding it owns as if it didn't already own it. One analyst spends a month building a bear case for the stock and another analyst works on the bull case. Phoenix's entire investment team then watches the two analysts debating the merits of the stock. This feeds into their decision on whether to change their funds' positions in the stock or not. Mr Chapple believes private investors should also review each of their investments in such a way every three years to ensure they do not hold on to shares for longer than is beneficial.
Ainsley To, analyst at wealth manager Credo Wealth, meanwhile, says you should spend the least possible time looking at your portfolio outside formal reviews. "As losses hurt twice as much, the less frequently you check your portfolio, the less likely you will be prey to loss aversion," he says. "But unfortunately, things are going in the opposite direction, with platforms offering apps that mean you can check your portfolio 24/7."
Mr Dillow points out that most of the cognitive biases investors are prone to encourage them to take too much action, so the simplest thing to do is to take little action. One way to do this is to be a passive investor by mostly holding tracker funds.
However, knowing about cognitive biases often is not enough to stop you falling prey to them. "If you've got tons of books on behavioural finance and you know all the mistakes that can be made, this means you're going to be overconfident," explains Mr Dillow. "So you've got to be careful about that as these biases apply to you, me and everybody else."
