Another summation on Biases

 BEHAVIOURAL BIASES

Munger stated that you should study behavioural biases and the errors they cause. Use your own words to describe them so that you comprehensively understand them, they are that important.

Loss Aversion

People feel the emotional impact of losses much more than gains. That leads to the inability to make a rational decision to sell at a loss, that decision could be warranted due to new information, old or new.  Our unwillingness to accept our mistakes and cut our losses will cause further pain.

Anchoring

The error is using irrelevant information as a reference point. In investing it is usually your buying price that becomes the reference point. Outside of your tax accountant, your buy price becomes irrelevant, the stock's valuation is what matters and that can deviate from a buy price. The market does not care what price you pay for a share. Consider issues with your valuation method and substantiate its robustness.

Mental Accounting

The error is bucketing capital differently according to where the investment funds originated.  That is, in your mind, money becomes not fungible, and risk/return is skewed by its source.  Easy come easy go etc.

Think carefully about bucketing, all money is the same regardless of source.

Availability and Recency Bias

The mind habitually uses information that is top of mind or has recently occurred to influence investment decisions. Critical information could be ignored or considered irrelevant due to being older or less accessible. Take all information into account and objectively weigh its importance.

Herd Mentality

Herding can be very damaging in investments; it is right up there. Many people, especially when confronted with fear, stress and not understanding what is happening will revert to a strategy of following the crowd. That could be in the bullish mode, FOMO (fear of missing out on gains) or the bearish mode, fear of sustaining further losses. Rationality and objectivity disappear and crowd following occurs.

The Narrative Fallacy

People are attracted to a sensible and comforting story. We can easily impose that story into investing situations that don’t fit. We see patterns that don’t exist and keep following a story when the facts mount that the story is a fantasy in our minds. The skill comes from differentiating and not being too dismissive or too believing.

Confirmation Bias

One of the big ones, the bias is where we seek out facts and opinions that support our initial assessment. Anything that differs from or criticises our views is ignored or denigrated. All facts should be objectively assessed, Munger goes further, you should be able to argue well against the best-resourced and able person holding an alternative view. Do not hide in a fool's paradise. One of the traps here is that you can think about an issue and generate a lot of output, but cherry-picking data and not assessing the complete set of facts leads to error.

Attention Bias

Attention bias is a bias towards buying those stocks that are constantly in the news, having not undertaken any or little analysis. Attention bias appears related to herd bias and recency/availability bias.

Familiarity Bias

This a difficult one, since investing in what you know well or is in your circle of competence is a strength and reduces risk. Familiarity bias can constrain returns if your competence is in structurally challenged investments and those sectors where long-term returns are not likely to be great. I'm in two minds about this one, however, it does speak to focusing your efforts on richer and potentially more lucrative fields. Making returns out of investments that don’t go anywhere over the long term is possible but has a higher degree of difficulty.

Emotional Reasoning

Being aware of our biases but cloaking them in legitimacy and using them with the belief they have scientific, rational and objective substance. I’m uncertain what to make of this one, hopefully, I don’t fall into this category. Yikes, we all know someone with this bias.  

Overconfidence

Another one of the big ones. “It's not what we don’t know but what we know for sure that just ain't so” (Twain). One of the problems here is that undeserved confidence in investing often means a big position is taken so the error (when/if made) is large.

There is an important distinction between gains made on thorough, objective, due diligence and gains /losses sustained just by confidence not backed by effort, reliance on luck is the difference.

Hindsight Bias

Quite a dangerous habit of investors is the “I knew it”, “if only”, “Should've, would’ve, could’ve” syndrome. The bias is rewriting of an outcome to believe it was more predictable. There are many possible outcomes before an event or over a set time, the outcome is one of many possible outcomes, they all have different probabilities and accurately measuring those possibilities is a skill. The variability of outcomes is difficult for many to comprehend, so we imagine we foresaw the events when we foresaw many things. An honest journal in real-time makes investors more aware of their initial expectations and thoughts on the probability of outcomes before the event.

Representation Bias

The bias of comparing a current situation with a past occurrence. Using analogies is a convenient way to simplify a story. Using past stories to replicate what is happening now can be erroneous. In some ways, it embodies lazy thinking instead of undertaking proper due diligence. Picking out appropriate linking can be quite tricky. Outcomes without doing the full work rely more on luck than objective assessment. I'm a sucker for this one.

Framing

The presentation of options using a set of data that may not include the whole set of data. Another form of cherry-picking data. Using cherry-picked data can lead to errors. Changing duration and scenario analysis will help avoid some of these errors.

Endowment effect

The bias of valuing an investment highly, because you own it. Treating investments like supporting a sports team ie, cheerleading, or political parties you support on principle not performance, the error comes in not properly evaluating changing operating environments due to poor internal decisions or deteriorating external dynamics etc.  Don’t use your loyalty for investments be objective.

Regret Avoidance

The fear of monetary loss through bad decisions leads you to avoid risk-taking. I suppose that is better than overconfidence but over time, risk avoidance can lead to significantly lower returns. Non-correlated investments (diversification), position sizing and due diligence to understand the extent of risk may help this bias.

Resulting

One of my favourites as it is so common—is the bias where the result justifies any decisions made to generate the result.  In many cases, the positive result was due to risky bets that paid off in this instance or a result of sheer luck. The bias arises because it is tough to differentiate luck from skill and where returns are due compensation for accepting excess risk. The instinct for investors, and one of business success/survival for professional managers, is to assign all gains to skill and all losses to unforecastable events. The real test is to ascertain whether the investment philosophy and process are repeatable over the long term. Luck and risk usually mean revert over a long enough investment period.

If you know someone who won Powerball, there is no doubt he won it, the money is in his account, and he probably doesn’t care about anything else. In this regard, would it make sense to ask him for the numbers for the next draw? Unless you can deduce the underlying investment process is replicable, it makes little sense to follow the punter.

Distracting Noise Bias (this is one of my own)

The distracting noise from market participants leads you to forgo your discipline to follow a well-thought-out and profitable LT strategy to follow participants that make a lot of noise and advertise large recent returns. The error here is not properly assessing the amount of risk, luck and style bias (as well as outright misinformation) hidden in these strategies. There is little context or attribution and usually no longevity. These strategies may arise out of a strong speculative bull market or a speculative theme that grips the market. Discipline is required to maintain your course and maybe tuning down the noise (mute them). You are battling significant instinctive biases, like envy, fomo, and the inability to rationalise why they are doing so well, even if this is over the short term.

 

CONCLUSION, So WHAT?

One thing about the uptake of social media is that information is spread like no previous time but with no applied filter. Even a quality sight like SM has enough material for a thesis on behavioural finance, let alone some other investing sights, lol.

There is no way I can say I am immune to the biases above, far from it. Even recognising them and trying to adjust is difficult enough. The impacts are quite personal so some biases may have no relevance for you but others seem too tough to overcome.  It is up to the individual investor to make their list and challenges.

I am quite susceptible to some of the above but immune to some others, being susceptible to some is quite enough. Regarding my own experiences, I would list, laziness, concluding without enough evidence, fear of missing out, clinging to a view and dismissing mounting evidence to the contrary, and going too wide and shallow instead of narrow and deep.  

These are quite important, it is too easy to dismiss any of our investing shortfalls and believe the error lies elsewhere, like not looking at enough opportunities. In my experience, I have had enough opportunities but then disregarded them without close analysis due to some of the above biases. Everyone will be different.

Writing these biases down in your own way and continually reviewing them would be very helpful in attempting to neutralise their impacts.