“A great deal of intelligence can be invested in ignorance when the need for illusion is deep.”
– Saul Bellow |
People’s eyes tend to gloss over when this sort of subject comes up (biases or beliefs or psychology), but it’s one of the most important things you can address as an investor.
When it comes down to it, most people are often really only thinking, “…just tell me what to buy!” But only wanting to know “what to buy now” is actually one of the 5 biases manifesting itself (more on that below).
You see, these biases are dangerous not only because of their effects on our decisions, but because they actually sabotage most investors without them even knowing it. In fact, several of these biases can actually make you feel like you’ve got sound logic behind what you’re doing. It seems reasonable.
You’ve heard of autopilot. Well, this is the opposite. This is auto-hijacking.
The technical term for cognitive biases is “Judgmental Heuristics”. That’s just a five dollar word for decision-making shortcuts. And, as humans we’ve developed these for good reason. There is so much stimulus in the modern world, that there’s no way we could handle it all without some shortcuts. But they do us a massive disservice when it comes to investing.
My hope is that an awareness of these biases can help make you a better investor. First, I’m going to outline each one, and then I’m going to show you how you can avoid them. It’s simpler than you might expect.
1. Greed & Fear
OK, so this first one is not technically one of the classic cognitive biases, but it is by far the most pervasive and has probably cost investors more than any other one thing. Greed and fear combine to create the investor trap.
I see this all the time in conversations and emails with clients and friends. They’ve bought the latest “hot” investment (FAANG stocks and Bitcoin, anyone?), and they talk about how much they’re up (on paper). Why did they buy it? Oh, they have their varied reasons, but, most often, why did they really buy it? Because they read about how it was going up. Because they heard a cocktail party anecdote about someone getting rich. Greed.
Then what happens if it starts to drop? “It’s at a discount – buy some more!” If it goes down still further? Well, it’s just a hiccup. If it goes down even more? “I’ll just hold it until I get back to even.” But eventually, the pain gets so intense, that they sell out at any price. Fear.
Investors do this individually, and en masse. In fact, it’s so common that’s it’s actually used as a counter-trend indicator. That is, when retail or individual investors, as a group, are massively bullish and most excited about stocks, it’s likely the top (and the professional money has already started selling and preparing for the imminent bear market). This is when your Uber driver is talking about his favorite stocks. Watch out below.
And the same thing happens in a bear market. When the last guy capitulates, throws in the towel and declares, “I can stand it anymore!” and swears, “I’ll never buys stocks again!” Yep, that’s probably the bottom.
There’s a great story that perfectly illustrates this bias – the Fidelity Magellan Fund under it’s manager, Peter Lynch. Lynch, one of the all-time great stock investors, managed the Magellan Fund from 1977 to 1990, and his average annual return over that time was 29% per year. That’s over 27 times your money in just 13 years! By any measure, that in an impressive return.
But here’s the kicker: Fidelity conducted a study to determine how their investors did over that time. What did they find? That the average Magellan investor actually lost money!
Why is that? It’s because investors were excited (aka – greedy) when the fund had a good run, and they bought in (which wouldn’t be the worst thing on its own). But when the fund had a down period? You guessed it – fear took over and they sold. This pattern held repeatedly throughout Lynch’s tenure.
The average investor in his fund made exactly the wrong decisions, at exactly the worst time. And they lost their butts.
2. Conservatism Bias
This is the classic, “We don’t believe what we see, we see what we believe.” This bias causes us to ignore, or not even see, evidence that’s not in line with our preconceptions.
This bias can be found in the most mundane of circumstances. We’ve all had one of these experiences. Let’s say you go into the kitchen to get the salt. You open the cabinet where it’s usually kept and you don’t see it. You call back toward the other room:
“Where’s the salt?”
“It’s on the second shelf.”
“No, it’s not there.”
“Yes, it its. It’s by the spice rack.”
“No, I don’t see it anywhere.”
“Yeah, it is! It’s right there!”
“It’s NOT here! Did you put it somewhere else?!”
Your significant other walks into the kitchen and grabs the salt off the shelf right in front of you, “What’s this?!” Domestic bliss was almost destroyed because the human brain, once it’s made up it’s mind, can be very resistant to contrary evidence.
And in our investing the conservatism bias can be far more insidious, causing us to subconsciously look for evidence that supports our established market theories – what we expect, and want, to see. And it can cause us to not see at all the sound, legitimate evidence that’s against our expectations.
You’ve heard the saying, “Good news is good news, and bad news is good news.” This is the conservatism bias becoming widespread, as it often does in a hyper-optimistic, late-stage bull market. Even the most highly respected experts are subject to this bias. This has occurred repeatedly through history, often right at the top of the market cycle. Just a few examples:
- 1929: Irving Fisher, leading economist and Yale professor, states that stocks had reached “what looks like a permanently high plateau…” and “security values in most instances were not inflated.”
- 2006: David Seiders, Chief Economist for the National Association of Home Builders says, “We’re now in the ‘middle innings’ of the current economic expansion, and the next economic recession is not yet in sight.”
- 2007: Ben Bernanke, Chairman of the Federal Reserve, says that “the vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.”
- Jan 2008: “The Federal Reserve is not currently forecasting a recession.” – Mr. Ben Bernanke, again, right at the top of the market.
- 2017: Bernanke’s successor, Janet Yellen says that another financial crisis is unlikely “in our lifetime.” (Time will tell on this one, but overwhelming evidence is not promising.)
The challenge in resisting the conservatism bias as a market phenomenon is that as the chorus grows ever louder it becomes harder to ignore, and an investor has an incentive to agree. We want the market to continue to rise, so it’s easier to accept the prevailing sentiment and only see those facts (news items, articles, statistics) that are in agreement. These are the times when one must be as ruthlessly objective as possible (more on how to help accomplish this in a moment).
3. Law of Small Numbers
I also call this bias “generalization” or relying on anecdotal evidence. It’s when we take a small number of examples and assume a trend.
The human brain is great at seeing patterns in the world around it. We quickly take a few examples and form a hypothesis about the world that we then use going forward. It’s how we learn not to touch a hot stove or that a saber-tooth tiger wanted to eat us. Great for survival, not ideal for investing.
You might as well use tarot cards for all of the information that…gives you about the future price of Amazon.
The amount of data that is created constantly in the market is almost not quantifiable. Add to that the massive amount of historical data available, and there’s no way that in can all be processed by an individual investor. So, without even thinking about it, we take a shortcut. We see a few promising events to which we assign causality.
“Well, Amazon was up big the last six quarters after they reported earnings! So, I’ll just buy Amazon right before earnings.”
But what does a move up over the last six quarters after an earnings report have to do with what will happen to Amazon’s stock after next quarter’s earnings? Effectively zero. What about one time accounting items, analysts’ expectations, overall market movement, investor sentiment, interest rates, tax policy, etc., etc., etc., etc? You might as well use tarot cards for all of the information that a small number of moves after earnings gives you about the future price of Amazon.
But investors do it all the time, especially in a late bull market. They have a few small successes because the entire market is going up, and attribute it their “skill” based on only a few examples. But as I’m fond of saying in a raging bull market, “Everybody’s a genius” (until they’re not).
4. Gambler’s Fallacy
This bias, as might be expected, is very apparent at the tables in Vegas. If you’ve ever played Roulette, you’ve seen this in action. Let’s say someone has decided to follow the sage advice to “always bet on black.” And let’s say they lose 5 in a row. What does the amateur gambler say? “5 reds in a row? Now it’s sure to be black!”
The odds of hitting one color five times in a row is relatively high – you’re bound to see it without too much time at the table. But the exact probability of that happening is irrelevant. Because regardless of what has happened on previous spins, what are your odds of hitting black on the next spin? They are exactly the same as they’ve been all night (47.4% – not good). (The record for a one-color run, by the way, was in 1943, when red came up 32 times in a row, the odds of that which are about 24 Billion to 1.)
The gambler’s fallacy is just that – the tendency to believe that the longer a trend is established, the more likely it is to reverse. And this is especially dangerous in investing. Unlike a situation with set odds or a normal distribution, a distribution of stock market returns has what are known as “long tails”. That is, the market can go up (or down) a lot more than you’d expect.
This what took down the hedge fund Long-Term Capital Management in 1998 (whose brain trust “included two Nobel Prize-winning economists and a cadre of Wall Street’s and academia’s elite traders”). They built their entire investment model on assumptions of normal distribution of market price action and massively underestimated the possibility of large moves against them. Their models broke down in spectacular fashion and the resulting losses endangered several Wall Street banks and almost the financial system itself (10 years before the 2008 Financial Crisis).
As Eugene Fama, another Nobel laureate economist, said: “If the population of price changes is strictly normal, on the average for any stock…an observation more than five standard deviations from the mean should be observed about once every 7,000 years. In fact, such observations seem to occur about once every three to four years.” In fact, we’ve had 50 such events since 1950.
Another way of putting it is, “The market can stay irrational longer than you can stay solvent.” Much longer.
5. Lotto Bias
Another gem from the world of gambling. The Lotto Bias bias is also known as the “Control Fallacy”. This comes, as the name states, from the ever popular (and highly unprofitable – except in the case of the state lottery boards that put them on) weekly lotto games.
The control fallacy is the increased confidence that comes with the illusion of increased control over the outcome. People think that because they pick the numbers, that their odds of success are somehow improved. Of course, their odds are exactly the same regardless of how the numbers are chosen.
For investors, this ultimately manifests itself in the question, “What do I buy now that will make me a fortune?” They think that if they get that one piece of information that they will have somehow improved their odds of an successful investment. But, once they’ve made an investment, the market is going to do what it’s going to do regardless.
Even Warren Buffett could only stand against the tide of the market for a short time – even his investment in, sale of, or comment on a particular stock only has a fleeting, temporary impact. Any feeling control of market action is just an illusion.
The Underlying Cause: The Being Human Problem
Again, we developed cognitive shortcuts for good reason. They help us navigate an increasingly complex world. There’s no way that we could process all of the information coming at us all of the time without that help. And while these biases are sometimes evident in our everyday life, they rarely cost us as dearly as they can when it comes to investing.
That’s because we are wired to feel particularly passionate about money. In fact, a Harvard Medical School study that showed that monetary gains activate similar parts of the brain as those in cocaine users doing a line. In other words, it hits us like a drug. No wonder we find it difficult to be rational in our investing decisions!
The Solution: Remove the Human (You) from Game-Time Decisions
The easiest way to counter these biases is to remove yourself from the day to day decisions. You see, the most dangerous time – when these biases are most likely to sabotage you investing – is in the heat of battle. When you have a down day in the market, or a down month or quarter. Or, counterintuitively, when you have a very profitable period and think you have it all figured out. These are the times when our biases can be most insidious.
The key to avoiding these biases is to separate the planning from the execution.
Of course, you should be the one who determines the goals for your investing. It’s your why. And that’s hugely important. And you should create, or at least be involved in, the formation of your plan for investing. The approach you use to reach your goals should be something that you’re comfortable with in terms of risk, beliefs, timeframe, etc.
The key to avoiding these biases is to separate the planning from the execution. In other words, you need do the work of thinking about your goals and formulating your plan beforehand – not in the middle of a trade or after a tough week. When it comes time to work your plan, you work your plan. And only make changes or do something differently after a thorough, objective assessment made with proper distance.
Work on the game plan before the game. Then, when it’s game-time, you execute the plan.
There are two ways you can be sure your execute your plan. You can choose to utilize one or both:
1. Automate as much as possible
This is why it’s best, for example, to have your retirement contributions taken directly out of your paycheck every month. The same should be true of your investing plan. Set automatic reminders to rebalance. Automatically reinvest any dividends. Set targets for profit or stops to limit losses.
Many online brokers and trading platforms have tools to help automate many parts of your investing plan. The more you automate, the more you’re removed from the execution of your plan. And the more removed you are from execution, the more game-time biases you avoid. And the better you execute.
2. Work with an advisor
A excellent advisor is a lot like a great coach. They have experience and can see the whole picture. They should work with you to formulate a plan that is a fit for your goals and priorities. However, unlike a coach in sports, an advisor can actually do the work of executing the plan. Your game-time biases become irrelevant.
The key here is that you haven’t outsourced your goals and priorities or the approach you’ll employ to reach them. You’ve outsourced the execution. And that helps you stick to the plan.
This is the true value of an advisor. Sure, they should have advanced strategies or tactics that can help you get a few more percentage points on your returns. They should be adept at utilizing some instruments that you’re not (like options, futures, etc.). Any advisor worth his salt will have experience and expertise, but their true value is found in disciplined execution of your plan.
And if you’re looking to improve on your current plan and ensure efficient execution, our investment approach does just that:
- We assess 61 assets classes and sub-classes all over the world for the best opportunities.
- Our defensive algorithms monitor every position to protect profits and avoid losses – we are sometimes 100% in cash when conditions warrant.
- Our quantitative futures component can make money in up or down markets.
We can help you avoid these biases – our approach is based on years of research and decades of data, and our execution is automated and systematic. We’d love discuss what we do and see if it’s a fit.
Please leave a comment, question, or get in touch. We’re here to help.