As the market is going a bit sideways after a mild earnings season, we are entering the famous “sell in May and go away” period, I thought of revisiting some investment biases we all experience at one point or another.
When I did my financial classes, everything seemed so well calculated and rational. Financial theories are so simple, so easy to understand, it’s impossible to mess up the application in the real world, right? Investors are rational individuals making sound decisions based on facts and just calculations…. Well this is what is being written in many financial books anyways!
Unfortunately, the truth is rather more complex. Emotions taint our judgment and have us do things that don’t really make sense. Since it is very hard to control our emotions, I thought it would be interesting to read about certain investment biases so it could ring a bell when such a situation occurs. At least, you will have the reflex of taking pause and to take a second look at a specific situation before pulling the trigger.
Over-Optimistic Bias
Once we make a purchase, we become more confident this was the right decision and that this company will provide a higher returns. However, the company’s situation didn’t change between the moment we analyzed the stock and made a purchase. However, our brain will tell us that this company is better once it is a part of our portfolio!
Scientific researchers have proven similar behaviors within the gambling industry where the team chosen becomes better in the gambler’s mind once he made his bet.
Confirmation Makes us Stronger
When we believe in something; we tend to give it more credibility and more weight to data, research and opinions confirming our belief. On the other hand, we tend to ignore or diminish the value of research and opinions going against our beliefs. This is because we like to find people that think like us and disregard people who challengeg our thoughts.
For example; if I find that Apple (AAPL) is an amazing company, I will give more value to Carl Icahn telling the world this stock should be traded over $200 instead of another investor explaining why AAPL is at risk.
Consensus Bias
If most investors in your environment agree that Johnson & Johnson (JNJ) is a great dividend stock and should be part of pretty much any dividend portfolio, it is hard to go against the crowd. The truth is, JNJ might not be such an amazing stock, but it “becomes one” since everybody is going in the same direction. Funny enough, we see that bias even with professionals!
Loss Aversion
This one is well known; it hurts more to lose $10,000 than it feels good to make $10,000. Go figure why, we are that kind of animal!
Price History
Many investors consider the price they bought as guide for the value of a stock. For example, if I bought RIM (now BBRY) at $65 (yes… I did that when I was younger) and the stock is now trading at $10 today, I could hold on to it thinking it will go back to its original value. As if the fact that RIM once worth $65 means that it will always worth that price in the future.
Fortunately, I sold it when it was around $45 and kissed it goodbye. Many investors hold on it since the stock was once worth over $200 and it has to go back… somehow.
Engagement
If we spend several hours and invested a big chunk of our nest egg in an investment, we tend to be more lenient and patient with it. We consider the energy and money invested and refuse to admit we did it for nothing. This is why people sometimes keep losers in their portfolio for a long time simply because they invested too much in it to acknowledge the loss.
Immediate Rewards
As funny as it is, losing hurts more than you can have pleasure winning, immediate rewards seem more important than long term success. Therefore, investors will tend to find the “cheap stock that will bounce back” quickly instead of buying a sound company that will grow slowly but surely over time.
Personally, I have divided my portfolio into two sections to manage this bias. I have a small portion of my portfolio invested in the hope of making immediate rewards (investment horizon of 18-24 months) and the rest is invested according to making money over the long haul.
Which Bias is Your Worst Enemy?
Throughout my 13 years as an investor, I’ve experienced many biases. Fortunately, I solved most of them and I’m able to make more rational choices. However, I still struggle to consider opinions going against my beliefs. I tend to ignore those articles or read them briefly thinking the writer is wrong and I’m right. However, no one is always right; therefore, reading opinions that question your beliefs daily is probably the best remedy for this bias!
What about you? What biases your investing decision?
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