The smart folks over at Magellan Financial Group have raked over the psychology of investing to come up with some helpful pointers on why investors often get it wrong and what they need to do to get it right.
The upshot: most of us are hard wired with biases that mean we oversimplify complex decisions and overestimate just how clever we are.
From Magellan’s yearly investor report, the pitfalls and what pros do to avoid them:
- Hindsight bias: “Hindsight bias is a tendency to see beneficial past events as predictable and bad events as not predictable ... In order to reduce hindsight bias we spend significant time upfront setting out in writing the investment case for each stock, including our estimated return. This makes it more difficult to ’re-write’ our investment history with the benefit of hindsight.”
- Bandwagon effect (aka, groupthink): “Bandwagon effect, or groupthink, describes gaining comfort in something because many other people do (or believe) the same ... We find no comfort in the fact that other people are doing certain things or whether people agree with us. At the end of the day we will be right or wrong because our analysis and judgment is either right or wrong.”
- Restrain bias: “Restraint bias is the tendency to overestimate one’s ability to show restraint in the face of temptation. This is most often associated with eating disorders ... In order to overcome our natural tendency to buy more and more of our best ideas we hardwire into our process restraints or risk controls that place maximum limitations on stocks and combinations of stocks which we consider to carry aggregation risk.”
- Neglect of probability: “Humans tend to completely ignore, or over or underestimate, probability in decision making. Most people are inclined to oversimplify and assume a single point estimate when making investment decisions. The reality is that the outcome an investor has in mind is their best or most probable estimate. Around this outcome is a distribution of possible outcomes, known as the distribution curve.”
- Anchoring bias: “Anchoring bias is the tendency to rely too heavily, or anchor on a past reference or one piece of information when making a decision ... We base our investment decisions on whether the share price is trading at a discount to our assessment of intrinsic value and we have no regard as to where the share price has been in the past.”
- Confirmation bias: “Confirmation bias is the natural human tendency to seek or emphasise information that is confirmatory of an existing conclusion or hypothesis. In our view confirmation bias is a major reason for investment mistakes ... In order to minimise the risk of confirmation bias we attempt to challenge the status quo and seek information that causes us to question our investment thesis.
- Information bias: “Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue ... In general, investors would make superior investment decisions if they completely ignored daily share price movements and focused on the medium-term prospects for the underlying investment and looked at the price in comparison to those prospects.”
- Loss aversion/endowment effect: “Loss aversion is peoples’ tendency to strongly prefer avoiding losses than obtaining gains ... In our view, all past decisions are sunk costs and a decision to retain or sell an existing investment must be measured against its opportunity cost.”
- Incentive caused bias: “Incentive caused bias is the power that rewards or incentives can have on human behaviour, often causing folly ... We prefer companies that have incentive schemes that focus management on the downside as well as the upside and encourage management to return excess cash to shareholders.”
- Oversimplification tendency: “In seeking to understand complex matters humans tend to want clear simple explanations ... If we cannot understand the complexity of a financial institution we simply will not invest, no matter how compelling the ‘simplified’ investment case may appear.”