Which cognitive biases are holding investors back?

Which cognitive biases are holding investors back?

critical for successful investors, cognitive biases, investors need to be aware of

Understanding and overcoming biases that can lead to investment mistakes is “critical” for successful investors, an Australian investment management business has said.

In an investment insight Hamish Douglass, Magellan CEO said that while cognitive biases can be “hard-wired” and make investors liable to “take shortcuts, oversimplify complex decisions and be overconfident in our decision-making process”, understanding the risky areas is a good first step.

He identified 10 biases that investors need to be aware of and outlined the strategies Magellan uses to mitigate them.

 

1. Bandwagon effect or groupthink

This bias sees investors gain comfort in an investment decision because many others are undertaking the same one.

However, the Magellan CEO said: “In our view, to be a successful investor, you must be able to analyse and think independently. Speculative bubbles are typically the result of groupthink and herd mentality.”

He added that successful investors should find little comfort in whether other people are doing the same thing or agreeing with them. “At the end of the day, we will be right or wrong because our analysis and judgement is either right or wrong.”

2. Oversimplification tendency

Most people prefer simple explanations, Mr Douglass said, but many investment decisions are “inherently complex” and don’t lend themselves to simple explanations.

He quoted Albert Einstein, who said: “Make things as simple as possible, but not simpler.”

Investors should remain within their “circle of competence”, Mr Douglass said. That means investors need to focus their investments in sectors that have a high degree of predictability, whilst remaining cautious of areas that are uncertain or complex.

At Magellan: “If we cannot understand the complexity of a financial institution, we simply will not invest, no matter how compelling the ‘simplified’ investment case may appear.”

3. Confirmation bias

A sister to bandwagon effect, confirmation bias is where investors seek out information that confirms an existing conclusion. It’s a natural human tendency, Mr Douglass said.

“In our view, confirmation bias is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made.

“This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong.”

He said investors need to challenge the status quo by looking for information that “causes us to question our investment thesis”.

4. Information bias

This bias involves using information that may be irrelevant in some instances, such as short-term stock movements, financial commentary or stockbrokers, to inform an investment decision.

Noting that investors are “bombarded” with “useless information” on a daily basis, Mr Douglass said: “Investors would make superior investment decisions if they ignored daily share-price movements and focused on the medium-term prospects for the underlying investment and looked at the price in comparison to those prospects.”

5. Incentive-caused bias

Mr Douglass said the sub-prime housing crisis in the US was a “classic case study in incentive-caused bias”.

He explained that incentive-caused bias is the way incentives or rewards can impact human behaviour to the point of poor decisions, in some instances.

To address this bias, investors should “evaluate the incentives and rewards systems in place to assess whether they are likely to encourage management to make rational long-term decisions”.

6. Hindsight bias

This tendency sees investors characterise positive past events as predictable and negative events as unpredictable.

Not only are these characterisations “as credible as a school child complaining to the teacher that ‘the dog ate my homework’”, they can also lead to poor decisions in the future.

He explained that this bias is particularly dangerous as it “clouds your objectivity in assessing past investment decisions” and as such, impedes investors’ chances to learn from them.

“To reduce hindsight bias, we spend significant time upfront setting out in writing the investment case for each stock, including our estimated return. This makes it more difficult to ‘re-write’ our investment history.”

7. Restraint bias

“The issue for many investors is how to properly size an investment when they believe they have identified a ‘sure winner’,” Mr Douglass said, explaining that restraint bias is when investors overestimate their own restraint.

“To overcome our natural tendency to buy more and more of our best ideas, we hard-wire into our process restraints or risk controls that place maximum limitations on stocks and combinations of stocks that we consider to carry aggregation risk.”

8. Neglect of probability

Similar to oversimplification tendency, this bias encourages investors to ignore, over- or underestimate probability when making decisions.

“The reality is that the outcome an investor has in mind is their best or most probable estimate.”

However, there is a distribution of potential outcomes, Mr Douglass said. In building a portfolio, investors should “distinguish between different businesses to account for the different risks or probabilities of outcomes”.

9. Loss aversion/endowment effect

This bias is investors’ preference for avoiding losses, rather than obtaining gains. “The loss aversion/endowment effect can lead to very poor and irrational investment decisions whereby investors refuse to sell loss-making investments in the hope of making their money back,” Mr Douglass said.

To nullify this bias, investors should consider all previous decisions to be “sunk costs” and all future decisions should be “measured against its opportunity cost”.

“We believe many investors would make superior investment decisions if they constrained the number of investments in their portfolios as they would be forced to measure opportunity cost and make choices between investments.”

10. Anchoring bias

This final bias prompts investors to “rely too heavily on… a past reference or one piece of information” in decision-making. This could be something like the recent share price.

To address this bias, Magellan bases its decisions on how the share price is trading “at a discount to our assessment of intrinsic value”.

Further: “We also have little regard to the prevailing share price in deciding to invest the time to research a new investment opportunity. We know share prices change and we want to have a range of well-researched investment opportunities so that we can act on an informed basis when prices move below our assessment of intrinsic value.”

Which cognitive biases are holding investors back?
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