People who are normally considered experts in their relevant field, often mess up when it comes to their investments. They act in ways that undermine their long-term performance.
This has nothing to do with intelligence, but everything to do with how our minds are wired and the behavioural biases we all fall prey to.
The reason being that our minds use mental shortcuts to help us make instantaneous decisions. While these are extremely useful, and can be lifesaving in certain situations, they are detrimental when we apply the same to investing.
STEVE WENDEL, Morningstar’s head of behavioural finance, shares an example.
Being an American, I have a special place in my heart, and stomach, for French fries.
Let’s say that I walk on a street in Mumbai, and I see two restaurants with French fries on display. I can very quickly get a sense of which one is going to be good. This gut feel – this intuitive sense, will help me out.
If there is no food on display, I will check the name of the restaurant and see if it rings a bell. If it’s McDonald's, my past experience will dictate whether I should enter or walk away.
What if neither name sound familiar. I will peep in and see the number of customers around. If I see no customers in one restaurant, and a crowd in the other, it’s a pretty good sign that one is more popular for a reason.
These are some of the shortcuts we use in our daily lives; the choices of other people, past experience, looking at price as a signal of quality, et cetera.
Now take those shortcuts and think about investing. Is this a good security? A frank answer should be, we have no idea. Intuition is a terrible guide when it comes to investing. It's not a very thoughtful and deliberative way to work out what is a good investment. A useful shortcut in daily life is terrible, when it comes to investing. We need thoughtful analysis of the underlying value of a security before we make a decision.
Morningstar’s behavioural finance team shares a few common cognitive biases.
Recency Bias. The belief that past performance is the best predictor of what's going to happen in the future. And of course, sometimes that happens with momentum. But to use past predictor as the sole parameter when investing in a stock or fund is a very bad move.
Herding. Look at where other people are excited and the stocks or sectors everyone is piling into. Following the herd is often quite dangerous.
Disposition Effect. In investing, lower prices, all other things being equal, is a darn good sign of the opportunity for profit. But individuals tend to hold the higher stock price as an anchor. For example, if you bought a stock at particular price and it's gone under that, you cling to the firm belief that you will hold onto it because it will retain that price. Even if you bought it during the peak of a searing bull run and stretched valuations.
Overconfidence Bias. The belief that I can beat the market because this hot tip from my brother-in-law is great. He has always advised me on the best places for a vacation or a meal, and he is always bang on.
Confirmation bias. Our minds selectively pay attention to and attune to the things that we already agree with. So, if you have a strong investing opinion on a particular sector, you will see lots of good information about why that’s a good investment. This is useful in life because it will help us pay attention to something that might be relevant to us. But it is not good when it comes to investing. Here it creates a feedback loop where you simply get a stronger and stronger view of the same investment and you can miss out on the contrary signals. You can miss out on what else might be happening and not make a firm and thoughtful judgement.
All these are examples of the shortcuts we use in daily life and misapply. These shortcuts are very wise for everything except investing.
Consequently, people are at odds with themselves. These shortcuts are natural and extremely useful in daily life. Hence, it feels good to do the wrong thing when it comes to investing. So follow the herd. Do what others are doing. Hug the benchmark. Use past performance as the prime indicator. That often feels good, because of the shortcuts that our minds use. But the normal rules of life are reversed when it comes to investing.
So, what do we do?
Steve Wendel says that you cannot eliminate the biases, but you can work around it.
Your brain is not going to change. It is how you are wired.
Change the decision-making environment. Create friction on that immediate choice. Slow down. Bring out that deliberative self. Bring out the more thoughtful slow processing.
Try the 3-day rule, or even less, say 48 hours. You will act on your decision after waiting for this period. This will help prevent any impulsive action. Shortcuts are about making fast decisions, making instantaneous decisions, that quick gut feeling. This will slow you down and help you think more carefully and constructively.
- Deliberate your decision.
To get around Confirmation Bias, play the devil’s advocate. Search for views that explain the other side of the trade. Let's say it's buying real estate. List the rational reasons someone would be selling real estate investments right now. Your mind will turn around you will look for reasons why selling is good. This will balance your buying thesis and make it more solid.
- Identify with a social group, not the masses.
Investors are impacted by environmental and media influence while investing. We always look at what other people are doing since it's a shortcut of our mind. Choose a group intentionally. Let’s say I am valuation driven investor. Look at what other contrarians are doing. Look at what renown value investors are saying. Make that your social group rather than the mass of people who are following current trends.
- Have a core investment belief.
This will help you stay the course when the market turns bearish.
Very few people change their fundamental view about how they want to raise their children. Very few people change their religion. Very few people change their fundamental political view of the role of person in society and what government should do.
During periods of volatility, revisit your core investing principle and thesis. Tie it to your deep personal goals.
When the sentiment is forcing you to act irrationally, keep the tax angle in mind. Have a core investment belief.
There is a study in the U.S. – just as someone was about to make a trade, the researchers popped up a warning saying you are going to pay this much in taxes, if you do this. If there is one thing that we hate more than losing money on an investment, its taxes. And it stopped people in that moment from making a bad decision.
All the above will help you get out of your head, onto paper. Finally, externalize by writing down the rules. Not only must you write out an investment policy statement but also specific rules. If the market drops 50%, what will you do or not do? If you like a particular hot sector, what rules will you lay down to determine entry or exit? Crystalize it. Put it in writing. So when you are tempted to react, revisit the rules you have set for yourself and think it through.
