Investing is simple but rarely easy. Why? Because we are emotional beings!
As Warren Buffet said, “Investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.”
So many emotions are in play once we invest our money. Our decision making becomes biased, and we are prone to making errors. Here are three common biases that are constantly at work in all of us.
1. Hindsight Bias
Hindsight bias says that we convince ourselves after the fact that we accurately predicted an event.
Take the global pandemic as an example. Hindsight bias would lead many to believe they had anticipated a stock market crash, while few actually did. Or the housing collapse and Great Recession—many would say that they saw the warning signals all along.
This seems pretty harmless, but how does it play out for an investor?
In our current situation, someone who saw their stock holding collapse during the early stages of the pandemic feels regret that they didn’t act. After all, hindsight bias is telling them they “always knew” this was going to happen. Looking back at the events of February and March further convince this person they were right.
Now the investor is kicking themselves for not acting earlier. Not only that, hindsight bias is giving them overconfidence in their ability to predict future market events. As a result, they are hyper-sensitive to react to events that could have an effect on the market (i.e. a second wave, the presidential election, etc.) because they think they will be right.
2. Self-Serving Bias
Self-serving bias attributes positive results to our own skill and poor results to bad luck or uncontrollable external factors. This acts as a sort of defense mechanism to protect our own self-esteem. Examples include:
- An employee taking credit for getting a job promotion but blaming his boss as the reason he got fired.
- A student attributing her talents for acing a test but blaming the teacher’s poor lessons for flunking a test.
Just like hindsight bias, self-serving bias can lead to an overconfidence in our own abilities.
The self-serving bias can lead to making unwise changes to an investment plan after an investor sees a track record of success. The old saying, “a rising tide lifts all boats” means that a bull market will make everyone’s stocks go up. To attribute this to your own skill is risky. Now you feel overconfident and might start doing things like:
- Having concentrated stock positions
- Increasing stock exposure to more than is prudent
- Trading more often
Even if a bear market occurs, you are likely to continue believing in your abilities since those market losses were caused by external factors.
3. Herd Mentality
Herd mentality refers to doing what the crowd is doing. I’ve talked before about FOMO (the fear of missing out), which is closely related. As humans, we are hard-wired to follow the herd. Part of it is social, and part is survival (think of a gazelle that is better protected in a herd than alone)
Investing with a herd mentality can be hazardous. Think of stocks with rapid price appreciation in the past. In finance, these are referred to as “bubbles.” For a bubble to occur, investors need to drive up the price of the stock, with little regard to the company’s actual financial position. The bad news about bubbles is when they pop—wealth is destroyed as the price comes back down.
Herd mentality is a primary cause of bubbles. Investors see “the crowd” making money and figure it’s a good investment. Or, they might be driven by FOMO. Either way, the investor’s decision-making ability is clouded by the bias of following others.
How to be a successful investor
The first step to overcoming your bias is to simply recognize they exist! Recognizing your tendencies, abilities, and shortcomings will make future investment decisions easier.
The second step is to focus on the investment process, not outcomes. While we undeniably need to be concerned about outcomes, a lifetime of positive results is because of great processes. In investing, so much is out of our control (global pandemics, anyone?). Focusing on what you can’t control leads to poor decisions with short-term mindsets.
For some, formulating a process to guide their investment decisions is too challenging. But, as we have seen, a solid process is essential for investment success. At Stewardship, we help people invest their money and stick to a long-term investment process. If you’re interested in learning how we can help you find investment success, schedule an appointment with one of our advisors.
