It’s true the stock market is an entity especially equipped to inflict the maximum amount of punishment on the largest number of investors possible, but it’s also true the investors it seeks to discipline inherently carry destructive behavioral biases which especially condition them for market abuse. There are reasons why the average individual investor consistently earns a long-term return equal to a tiny fraction of the market itself, and why active professional money managers can seldom match the return of the broad market, the biggest of which is these destructive biases. In our quest to learn how to consistently make wise investment decisions, let’s identify the worst of these prejudices and replace them with knowledge and an investment process that gives no voice to emotions.
- Recency Bias occurs when an investor considers recent market returns when making investment decisions. Absent a consideration of real market influences, this prejudice will often lead to buying at market peaks and selling at market bottoms. Solutions include regular account rebalancing and closely following an investment policy statement.
- Confirmation Bias seeks support for an erroneous view which masquerades as investment research, and often devolves into an obstinate rejection of facts. The simple acknowledgement that truth will disprove every natural opinion we have will invigorate the due diligence which produces an informed decision.
- Ownership Bias believes an investment holding is more valuable because we own it. Illogical and full of hubris, this partiality often leads investors to double down on losing positions, which can crush portfolio returns. An effective solution to this malady is a commitment to run with winners and dump losers with ruthless expediency.
- Loss Aversion Bias results from the typical predisposition investors have to feel the pain of loss more profoundly than the pleasure of an equivalent gain.¹ This ailment leads to a refusal to unload losing positions and/or an assumption of more risk to make up for the loss, a solution for which is the establishment of an exit plan at the time of purchase for all non-forever holdings.
- Arrival of Humanity Bias appears at major market peaks, convincing vulnerable investors via mainstream news sources that stocks will never significantly decline again because “it’s different this time”.² Understanding “There’s nothing new under the sun” (Ecc. 1:9), coupled with a recognition of the natural market peak-trough cycle, will protect you from a false idea that has claimed the financial lives of many investors.
Two final thoughts on neutralizing the biases which will otherwise neutralize your investment capital are a) realize you are not exempt from these biases; in fact, they especially apply to you, and b) to benefit you, truth and facts must be acted on; establish and closely follow an investment policy statement which will give emotions and biases no voice in your ongoing pursuit of consistently making wise investment decisions.
Think about it, God bless your efforts, and Happy Thanksgiving! Shaun.
“Every good gift and every perfect gift is from above, and comes down from the Father of lights, with whom there is no variableness, neither shadow of turning.” ~James 1:17-18
1 PIMCO, “Behavioral Science Reference Guide”
2 “The Little Book of Behavioral Investing”, James Montier
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the author.