KNOW YOUR WEAKNESSES, BE A BETTER INVESTOR
Roy Davidson, 22 November 2018
It is tempting to think of investing as a science - you plug some numbers into a spreadsheet and out comes the answer. However, there’s a lot more to it than that.
Before making an investment, an investor needs to form a view on such things as the market structure in which a company operates, its competitive advantages, the strength of its management, potential risks, and how earnings are likely to react should economic conditions change.
On top of all of this, there are several behavioural biases that can impact all investors from time to time, leading to poor investment decisions. Knowing about these biases, and when you may be influenced by them, can help make you a better investor.
Five of the most common behavioural biases that impact investors:
1. CONFIRMATION BIAS is the natural tendency for investors to place more weight on information that agrees with their view, and less on those that don’t. This can result in an unbalanced view of a company’s prospects. An investor with their ‘blinkers on’ can potentially misjudge the prospects of a company and be caught unaware should things take a turn for the worst.
2. RECENCY BIAS is where people recall more prominently events that have happened in the recent past, over those that happened some time ago. For example, a poor result or short-term issues from an otherwise high quality company, can cause investors to become overly pessimistic, creating a good buying opportunity. Or, vice versa, investors may extrapolate good recent performance far into the future when this is unlikely to be the case.
3. LOSS AVERSION relates to the fact that humans tend to feel more pain from a loss, than pleasure from an equivalent gain. This means an investor can be reluctant to sell shares that have fallen, as opposed to those that have risen, as the pain from the loss will be felt much more acutely. This can result in an investor holding on to shares they probably would be better off selling, in the hope of some-day making their money back.
4. THE BANDWAGON EFFECT is the tendency for people to go along with the crowd. After all, this herd mentality would have been quite beneficial back in caveman times. This behaviour is often seen during bubbles where investors jump on the bandwagon just because everybody else is doing it, despite not really understanding what they are investing in. A good recent example is bitcoin. Good investors are able to think independently, even though it can feel somewhat uncomfortable standing on your own.
5. ANCHORING BIAS is where investors rely too heavily on one particular piece of information, often the recent share price of a company. In practice, this may cause an investor to purchase shares in a company whose share price has fallen from where it was previously trading, as they are ‘anchored’ to the old price and the stock now appears cheap. However, where shares are trading now compared to where they have been in the past, doesn’t really tell us much about whether it is cheap or expensive.