How to avoid the most common investment mental pitfalls

This post has my reflections from this insightful article by James Montier: Part Man, Part Monkey

In investing we are all likely to suffer from heuristics and biases. Heuristics are just rules of thumb that allow us to deal with information overload. However we all think that we are less prone to bias while the rest of the world has more bias. This is our bias blind spot.

The most common biases we face as investors are:

We are overoptimistic and overconfident. This is because we have the illusion of knowledge. We think that more information means better information and knowledge, but this is not the case. We think we have influence over the outcome of uncontrollable events: the illusion of control.

Every information has two components: strength and weight. Weight means how important the information really is. Strength means how good it is projected. There is generally underreaction to high weight and low strength recommendation and overreaction to low weight and high strength information. Dividend policy changes are high weight and low strength and historically high earnings growth is low weight and high strength.

We have a very bad habit for looking for information that agrees with us.  This habit of searching for agreement rather than refutation is called confirmatory bias. Moreover if we find information that refutes us we tend to view that information as biased( hostile media bias).

We want to protect our self-image, which is quite fragile. This is called the self-attribution bias. We attribute good outcomes to skill and bad outcomes to bad luck. In reality: good outcome+ good reason=skill, good outcome+bad reason=luck, bad outcome+ bad reason=mistake and bad outcome+good reason=bad luck.

After something happens, we are all very sure that we knew it beforehand. This is the hindsight bias.

We anchor to irrelevant things. We think price is equal to value. What we need to do is look at prices and see what is the estimation of growth of decay that is embedded in the price.

We judge things by how they appear rather than how likely they are. This is the representative bias. Like we project past high earnings growth to the future and do not understand that earnings growth is means reverting.

People are more likely to recall vivid, well-publicized or recent information rather than the truth. They are also more likely to rely on their own experiences to statistics or the experiences of others. This is because of emotion and this is called the recency effect.

The way information is framed can influence our decisions and investors and analysts often suffer from narrow framing or frame dependence. This is because of our cognitive limits to deal with too much information and inattentional blindness, when we cannot something when we are engaged with an attentionally demanding task.

We like to maintain the status quo and therefore do not act( status quo bias) and place higher value on something that you own compared to what you don’t own ( endowment effect). This is because of loss aversion– we dislike losses more than we like gains.

Some rules that can help us deal with these biases are:

  1. Accept that these biases apply to me, you and everybody else.
  2. You know less than you think you do.
  3. Try to focus on the facts, not the stories.
  4. Be less certain in your views and aim for timid forecasts.
  5. More information does not equal better information.
  6. Think whether a piece of information is high strength and low weight, or low strength and high weight.
  7. Look for information that disagrees with you.
  8. Your failures are not just bad luck; examine mistakes to improve your performance.
  9. You did not know it all along, you just think you did.
  10. Set up a sensible valuation framework. Forget relative valuation, forget market prices, work out what a stock is worth. Do reverse DCF and see what growth is implied in the price.
  11. Judge things by how statistically likely they are, not how they appear to be.
  12. Don’t overweight personal experience.
  13. Bid, vivid, easy to recall events are less likely than they really are. Subtle causes are underestimated.
  14. Don’t take information at face value; carefully look at how it is presented to you.
  15. Don’t confuse good firms with good investments, or good earnings growth with good returns
  16. Don’t value something more, just because you own it.
  17. Sell your losers and ride your winners.

When I look at this sort of information, one of the best things that one can do is to invest in globally diversified low-cost indices spacing our investments over time, rebalancing and holding forever.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s