The Biased Investor: Putting it Together
So how many are there?
Blind Men Appraising an Elephant. Edo Period Illustration. Source: Brooklyn Museum
How many mental mistakes can we make? We’ve discussed loss-aversion, overconfidence, herd behavior, and all kinds of cognitive biases. But there are lots more: Wikipedia lists over 150 different kinds of mental errors, from anchoring to the money illusion to the zero-sum fallacy. People are intuitive thinkers. Often, there just isn’t time to think things through. If an oncoming car changes direction and starts to head towards me, I need to get out of the way NOW—not after I’ve calculated his speed and direction and how close the nearest hospital is. But our intuition is imperfect, and leads to less-than-ideal outcomes.
In general, there are three types of errors: those that come from our own beliefs, those that come from being part of a group, and those that come from our distorted memories. You could say that individual errors tend to cancel each other out when a broad and diverse market has developed. But when social biases and herd behavior come into play, the entire market can appear to be rushing off a cliff. Crowds have their own dynamics.
Photo: Kashfi Halford. Source: Wikipedia
Cognitive errors can cost us dearly. Whether our loss-aversion leads us to underinvest, or our homeward bias causes us to favor companies from our region, our portfolios tend to reflect these systemic issues. What can we do about them? One part of the answer is to slow down. High frequency trading may work in milliseconds, but most investment opportunities are around long enough for you to examine the business case. Take the time to do some research. If someone tells you that a fund is closing soon and you need to decide immediately, it’s probably better to walk away. A high-pressure sales pitche and rational calculation don’t go together.
Second, leave some margin for unexpected developments. It’s been said that markets are random, but really, it’s the news that’s random. I may buy shares of GE because I like their financial position, their business model, and their management team takes shareholders seriously. But if the CEO announces he has cancer tomorrow, that’s a piece of news I can’t plan for—and the stock will likely go down with the uncertainty that such an announcement would create.
Finally, stick to your own investment plan. Investment strategy has to do with our personal goals and constraints—what return we need, how long we have, what legal restrictions there might be, and so on. Our strategy doesn’t change because the market is over or under-valued. Even if an investment is a genuine bargain, it might not be appropriate for you. Your plan should be tied to your total financial picture.
Markets aren’t totally rational. They’re made up of people, and people aren’t rational. We’re affected by our emotions, our memories, and the shortcuts we use in our thinking. But if we take the time to think things through, we’ve got a better chance to reach our objectives. And that’s the unbiased truth.
Douglas R. Tengdin, CFA
Chief Investment Officer
[cognitive biases, herd behavior, planning]