3 Biases That Are Ruining Your Investment Decisions (and How to Overcome Them)
I know it’s hard to believe. Particularly about ourselves.
Biases? Not me. Others, yes, but not me.
Unfortunately, we all have them. They are hard-wired. Billions of years of evolution will do that.
Let’s discuss the 3 most common biases that I notice investors, particularly novice investors, suffer from.
They are the following:
- Recency Bias
All biases conspire to do one thing— convince us we know what the future is.
Investing, after all, is about placing money down for future returns.
But when it comes to predicting the future, humans are naive. There may be other species out that that can do a good job.
Let’s start with one of the biggest and most damaging biases we have.
I’ve suffered from it, and bad. Read here about the time I lost a million dollars.
And I see it in others all the time.
Overconfidence is a killer and it can cost a fortune (literally). Even worse, it can knock you out of the investing game forever.
So where can overconfidence come from?
Generally, it comes from making a few profitable trades; you’ve made a decision, even based on no evidence, and it’s paid off.
In this position, do you think to yourself, I was lucky? Could have happened to anyone? Next time I could be wrong?
Unfortunately, with a few wins under your belt, it’s easy to think you have a gift.
That’s the overconfidence bias.
Out of all the biases I mentioned above, overconfidence is the one that is most likely to lead to financial disaster.
Let me explain.
When people ask me what are the top things you SHOULD do as a new investor, I say lose money first. It’s not the most popular advice I give, I must admit.
But to keep in the investing game for the long haul, losing money quickly is often the right medicine.
I am not talking about losing enough money to wipe you out. Just enough to hurt. Enough to remind you that you can and will be wrong; that we are all fallible and that, no, we don’t know the future.
What are the downsides to overconfidence?
Overconfidence has two main downsides that combine to be a formidable bias.
- It leads us quickly into making too large a bet. And why wouldn’t you? After all, as an overconfident investor, you are always making the right decisions. Right? You are always ahead of the market.
- When things turn bad, and they will, you don’t have the mental fortitude to deal with it. You just stick to a losing position. Because selling means you were wrong; selling means that your ‘overconfident’ belief in yourself was a lie.
Making a too large investment in a losing position that you won’t sell is the perfect recipe for losing all your money.
How do you avoid the overconfidence bias?
There are three main ways you can kill overconfidence before it destroys you.
- Recognise that you don’t know the future. Remind yourself, NOBODY is good at predicting what’s going to happen next.
- Never invest more than you can afford to lose. Never make an investment where, if you lost everything, it would wipe you out.
- Build-in objectivity.
This affects both new and sophisticated investors alike.
In my early days on Wall Street, there would be a number of people sitting on the trading desks who would use ‘models’ which showed the stock prices going up and ‘magically’ predicting it to go up further into the future.
I used to call them ‘chartists’.
They were pretty much all gone within 5 years.
What were these people doing?
They were extrapolating from insufficient information. They believed that they could predict the next price move based on the previous movements.
The problem is, as humans we are built to find trends, patterns, sequences—even when they don’t exist.
Once I was on the trading desk and had a random number generator to help me calculate some option prices. These are complex financial products that I will cover in future articles.
The number of people that would come to my desk, stare at the screen and tell me where they could see the pattern was amazing. And concerning.
They were just random numbers!
How do you avoid the extrapolation bias?
It’s easy to avoid this kind of bias.
- If you think you can see a pattern, think again. Even truly random distributions appear to have patterns.
- Remember that the next move is not based on the past; it is based on new information. That’s the place to focus.
3. Recency bias
Recency, our focus on today (not the long-term), really lets us down in the investing game.
Warren Buffet says that the reason we can’t all be like him is that so few want to get rich slowly.
We want to get rich quick.
And to get rich quick, you look around and see what’s making money NOW. What is doing well NOW? What are the winning funds and stocks?
There’s that warning, “past results are no prediction of future results” that, unfortunately, everyone tends to ignore.
Recency bias also means we make decisions on our own recent experiences and the way we feel about them.
But investing doesn’t work like this.
Investing is about the future and is often breaking the bounds of the current world.
Let me give you a quick example.
My feeling when the new Apple iPhone came out in 2007 was that it was a) way too expensive and b) way too big.
Because of my own feeling about phones at the time; Nokia made small relatively inexpensive phones.
Everyone wanted a small and inexpensive phone, right?
But the iPhone was breaking the mould. It was creating something totally new.
Recency, or my own experience up to this point, was of no help to me here. In fact, it was leading me away from an excellent investment.
Luckily for me, I was aware of my biases and made an investment, in Apple, accordingly.
How do you avoid recency bias?
- Look at counter-arguments to your ‘gut feel’—there will be plenty of people that have different view to you; listen to them.
- Think to yourself, am I just thinking of my own experience?
- Remind yourself why you have come to a particular conclusion. Make sure you are not just justifying your position but that it comes from solid ground, not ‘recent personal experience’.
Those are the 3 biases that can ruin your investment decisions.
Have you found yourself at the mercy of any of these? I sure have. It’s easy to do.
If you find it difficult to work past any of these elements and find success in your investments, you should talk to a financial advisor. They will be able to help set you up for a great future.
- We all suffer from biases, even professional investors.
- Recognise that nobody really knows the future.
- Don’t invest more than you can afford to lose.
- Don’t rely on the recent past to make decisions about the future.
- Talk to other people who have different experiences before making a decision.
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This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.
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Who is Paul Atherton, That Wall Street Guy?
An ex-Wall Street advisor who worked with major players in the global financial industry for over 30 years, Paul’s mission is to help regular people reclaim their wealth and financial security.
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