Four Cognitive Biases That May be Affecting Your Portfolio
Being a successful investor takes a great deal of skill and knowledge. Hours of studying, insight and initiative are needed to be able to consistently make high (or better yet market-beating) returns on your savings. However, perhaps the most important aspect of all is to do with our psychology! Benjamin Graham, the ‘father’ of value investing and mentor to Warren Buffet, frequently stated that a good investing strategy won’t succeed if the investor doesn’t have the right temperament.
In fact, Graham alluded to two types of investors – a ‘Defensive’ (passive) investor and an ‘Enterprising’ (or active) one. The defensive investor is one that is happy earning a market average return, and is not interested in constantly monitoring their portfolio, whereas an enterprising investor is willing to put the work in to beat the market. Indeed, most peoples’ temperaments are suited to the former option, due to a multitude of cognitive biases that affect each and every one of us, and cloud our judgement as investors.
Some of the most significant biases we have that relate to investing are listed below.
- Recency Bias: The first on our list (and most damning) is ‘recency bias’. This is where we have the tendency to believe that what has happened lately will continue indefinitely, the most notable examples being bull markets and recessions. This also holds true for share prices – we have an innate urge to believe that our share prices will just keep rising when they are doing well, and vice versa for when they fall, based on past performance.
- Confirmation bias: The second bias complements the previous well – what’s known as ‘confirmation bias’. We have the tendency to emphasize information that confirms an existing belief or viewpoint. We like to read about the articles that prove us right, not prove us wrong! This can go to explain why some investors become so overconfident with their portfolio, as they go to ‘cherry-pick’ data that reinforces their gut-feeling.
- Loss Aversion: Loss-aversion is just as significant. People place a higher value on what they own than what they do not. Hence, it hurts more to lose 100 pounds, than it feels good to win the equivalent amount – we are thus less likely to sell when our investments are down, than when we are up! This effect shapes our investment decisions, when really, the share price should have very little to do with a proper investment strategy.
- Herding Behaviour: The final entry on this list of important cognitive biases is the Bandwagon effect. It is a lot more comfortable to go with a crowd than it is to go it alone – hence why speculative runs and bubbles can occur all too readily in financial markets, which was clearly observed in 2008.
So, what do these biases mean for a portfolio? Essentially, the bottom line is that short-term share prices have a huge impact on investors. We are constantly bombarded with news and forecasts telling different stories about what a certain price change means for a company, and how you can make money from it. However, as Warren Buffet puts it, ‘the worst mistake you can make in stocks is to buy or sell based on current headlines’. The safest way to manage your money instead is to follow a disciplined set of rules that stop you from making impulsive decisions.
Terms like; Price/earnings ratios; working capital; current ratio; book value, et cetera. All of these fundamental statistics paint a more accurate picture of a company than its short-term stock price, and any investor looking to do well in the market should learn of these barometers, to try and beat their inner impulses and that dangerous ‘gut-feeling’.
Simple formulas work as well; for example, setting yourself the rule that 50% of your portfolio must be in stocks while the rest is in bonds, and then rebalancing the portfolio in 6 months-time to account for change is a great strategy that instantly cures the confirmation, loss-aversion, bandwagon and recency biases! Investing partly in index trackers or investing based on ratios and not price are also fantastic methods. With this advice, hopefully the amount of money you lose to impulsive or irrational decisions will gradually decrease.