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ISA season and the new tax year are as good a time as any for a spot of portfolio spring cleaning. But in making the decisions to add new positions and cut back others, there are potential pitfalls to be aware of. Billions of years of evolution have wired humans to think and act in certain ways - but they’re not always well suited to the stock market.
Psychologists have identified hundreds of cognitive errors and emotional biases at work in the human mind. For the most part, they fall into two categories:
The good news about the first group is having them pointed out is apparently often enough to overcome them. With that in mind, there’s a subset of those pitfalls that are of particular interest to investors. They fall under the banner of Belief Perseverance, or cognitive dissonance.
One look at the phrase Belief Perseverance will probably have some investors nodding knowingly. These are the subtle cognitive errors that lead us to cling on to beliefs, opinions and convictions even in the face of overwhelming evidence to the contrary - and they can be costly.
Let’s have a closer look...
We’ve covered it before, but Confirmation bias is a big challenge for investors. After making a decision, it leads individuals to gravitate to information and opinion that agrees with what they already think. In simple terms, there’s a risk of falling in love with a stock and losing all objectivity about it.
With easy access to vast amounts of information and discussion on the internet, it’s never been easier to seek out and find confirming views. With broker research becoming more increasingly accessible, it’s equally possible to find comfort in the words of favourable analysts. But these too are prone to cognitive errors (see Conservatism bias next).
The associated risks are huge. Confirmation bias can create a false sense of confidence and a willingness to join herds of other besotted investors who are seduced by a story. Contrarian investment strategies (such as those used by David Dreman) have been created to take advantage of those suffering from Confirmation bias, so avoiding it is essential.
Conservatism bias is when individuals prioritise their original beliefs and expectations even if new information shows they should change their minds. This is a problem that’s often linked with analysts but it applies to investors, too.
Like Confirmation bias, Conservatism bias puts the investor (and analyst) at risk of under-reacting to new and perhaps more accurate information. This lagging reaction is known to be a cause of price momentum, which other, more rational investors can take advantage of. (Stockopedia covers a range of Momentum strategies that are based on just this type of investor behaviour).
James Montier, a respected equity strategist and behavioural finance expert, believes Conservatism is often caused by something called the ‘sunk cost’ fallacy. This is where decisions are heavily influenced by what an individual has already done or invested, rather than being rational and objective.
As such, it’s a bias that could conceivably lead to investment decisions like ‘averaging down’ on a losing share or buying more shares in a holding that’s just issued a profit warning. It might turn out to be the right call, but statistically - particularly in the case of a profit warning - it won’t be.
In The Little Book of Behavioral Investing, Montier explains: “This is a tendency to allow past unrecoverable expenses to inform current decisions. Brutally put, we tend to hang onto our views too long simply because we spent time and effort coming up with those views in the first place.”
Hindsight bias is what happens when an individual feels that they knew an event was going to happen before it did, even though there’s no justification for it. Psychologists have shown that surprising events tend to reframe all our previous thinking and the big risk is that we become overconfident in predicting the future (because we “knew-it-all-along”).
One expert on this is the renowned psychologist Daniel Kahneman. In his book, Thinking Fast and Slow, he explained that the core of the Hindsight bias illusion is that we believe we understand the past, which implies that the future should be knowable. But in fact, we understand the past less than we think we do.
In his book Contrarian Investment Strategies, US fund manager David Dreman makes the point that Hindsight bias significantly limits what can be learned from experience. He wrote: “As a result, we think mistakes are easy to see and are confident we won’t make them again - until we do.”
If Hindsight bias is all about overestimating our ability to predict past events, take that a step further and you get Illusion of Control. This is about overestimating our ability to control the present.
Some psychologists have suggested that this human mind quirk is driven by a desire to avoid uncertainty. Rather than following the advice to “don’t just do something, sit there”, actively tinkering with a portfolio gives the Illusion of Control. It’s credited for a range of damaging investing habits, including overconfidence and costly over-trading.
In James Montier’s words, Illusion of Control seems most likely to occur when lots of choices are available; when you have early success at the task; the task you are undertaking is familiar to you; the amount of information is high and you have a personal involvement. In other words, precisely the condition that you’re like to encounter when investing.
Finally, Representativeness is a tendency to take new information and force it to fit with an idea or a narrative that we’ve already formed in our own mind. Falling for this can make it difficult to accurately assess new information - like financial results or stock price movements - and be objective about it.
Research shows, for example, that investors buying investment funds suffer from representativeness by believing that recent performance is overly representative of a fund’s future prospects. In other words, they predominantly chase past performance and are unrealistically optimistic about the odds that fund performance will continue.
In his book, Investment Blunders, behavioural finance academic John Nofsinger says that representativeness can cause investors to buy stocks that represent the qualities they desire.
He wrote: “One quality investors prefer is an increase in the stock’s price. Because of the representative bias, investors expect an increase in a stock’s price after witnessing the price increase in the past. That is, people tend to project the previous trend into the future.”
In their book, Superforecasting, Philip Tetlock and Dan Gardner noted that ‘beliefs are hypotheses to be tested, not treasures to be protected’. That neatly sums up the view of many psychologists when it comes to avoiding the Belief Perseverance pitfalls that can undo investors. Simply being aware of these challenges is part-way to overcoming them, but behavioural scientists do offer more practical avoidance tips too. Here are a few ideas:
About Ben Hobson
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Hi Ben,
Thanks for the interesting article.
Is there some contradiction between the following two statements in your article?
"Like Confirmation bias, Conservatism bias puts the investor (and analyst) at risk of under-reacting to new and perhaps more accurate information. This lagging reaction is known to be a cause of price momentum."
“One quality investors prefer is an increase in the stock’s price. Because of the representative bias, investors expect an increase in a stock’s price after witnessing the price increase in the past. That is, people tend to project the previous trend into the future.”
Although the evidence for individual behavioural biases is compelling there's no grand unifying theory of how they fit together. But I'm not sure conservatism and the representative bias are necessarily contradictory.
Conservatism says that people will ignore new information and carry on doing what they previously did. The representative bias says that if the price has gone up (or down) previously people will expect it to carry on going up (or down). So basically people ignore new news and assume that a share price will continue to do whatever it did in the past.
The issue with under-reaction is that it can work both ways: both good and bad news isn't fully priced in. There's a bit of evidence that this is to do with limit orders - so good news triggers a price rise, which is throttled by automated sell instructions while bad news triggers a price fall which is halted by automatic buy instructions. But the evidence is mixed as to whether this is psychological issue or a technical one. Probably a bit of both.
timarr
timarr is too modest to mention it directly, but anyone interested in how psychological biases intersect with finance should check out his blog, it's a great read:
http://www.psyfitec.com/
Ben, your article today gave me just the very impetus I needed to clamber off the fence and sell, at a loss, a share I had held irrationally for some time, despite all the obvious signs. I do hate to sell anything at all and to crystallise a loss cuts me to the quick, but this company, Interserve, has gone too far and so fallen out of my basket of criteria. It could have been a lot worse had I not banked a fair few divis over the years and just once, sold high and bought back. It would have been less galling had I not bought more after the rest of the world it seems had smelled a rat. but, despite the slight feeling of a slapped leg, I have to own that I do feel a lot better already. Many thanks
Here here - timarr's blog is one of the best on the web on behavioural finance. I've lost (gained) weeks in there. http://www.psyfitec.com/
"Constantly challenge assumptions about a stock"
There is a problem here though. It's very difficult to run a winner with a mindset of constantly challenging why you own it.
Yes I agree, it's easy to get talked out of a share. I recall Boohoo.Com (LON:BOO) so many negative comments last year. I think you can read far too much, think you need to make your own judgement. Look at the most successful shares over the last year or so and see there is usually people finding reasons not to invest, quite amusing reading old reports. Also the more a share goes up the more people will say it's too expensive and sometimes they are right but often they keep on going up, read Mark Minervini interview, buy high and sell higher. But this is what makes the market. Biggest mistake I and many others make is selling out too early. I'm looking more at charts to guide me when to sell.
Thank you for the kind comments: I've been on sabbatical due to ... well, life mainly :) Restarting soon.
On shipoffrogs comment - yes, I agree that you can't constantly re-evaluate, but the important thing is that you do so periodically. There's some decent research (I'd have to go dig it out, but I think it was Thaler and deBondt) which suggests that the more often you look at your portfolio the more likely you are to over-trade: so constant re-evaluation is probably damaging as well. The research is full of contradictions, but there is a signal in among the noise.
Personally I settle on a six month review, unless there's some major newsflow. Although I increasingly keep an eye on StockRanks for changes. They're not perfect - nothing is - but they often indicate a change that needs looking at.
But running winners and cutting losers: absolutely. I'm minded of George Soros who says he's had many many more losers than winners. But when he loses he sells early and when he wins, he wins big. Easy to say, hard to do.
timarr
Hi Tim, I'm not keen on fixed review dates, I have seen systems that use them and have lost a lot of profit, I recall Pan African Resources (LON:PAF) was the top performer up 50% but by the time the review came around it was back down to about 10% profit then it was sold, I don't think there was any major news. But it depends what sort of shares you buy, for momentum based ones I would want to be reviewing daily, things can change pretty quickly, for income based ones don't even need to review every 6 months.
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I agree with the above.
I also think that having a sound decision making processes, and always following them is the best approach.
Eg I have a process that I must follow before deciding whether to sell, or continue to hold, a share. Just before making the decision, I have to complete two sections. These are "Best reasons to continue to hold" and "Best reasons to sell"