One of the least recognised failings of retail investors is their lack of self awareness or understanding of cognitive biases. A cognitive bias refers to a tendency to think and interpret people and/or situations without rationality or good judgement, systematically generating your own “subjective social reality” based on your perception, rather than logic or facts.
The ugly truth is that the errors made through poor choice and badly timed investments can heavily outweigh the perceived benefits of managing one’s own account.
Private investors are seduced by the idea of easy money investing in equity markets, but the reality can be a whole lot different. Investors find their stress levels rising when they have to make buy and sell decisions on their own, in real time, and become overwhelmed with conflicting information. It’s just not easy!
Four cognitive biases
There are four main cognitive biases that can have a dramatic impact on the performance of a stock portfolio; they are anchoring, saliency, herding, and confirmation bias. Investors need to be aware of these four cognitive biases, in order to be able to avoid the damaging effects on the performance of their portfolio.
An example of anchoring could be when a stock starts to lag the market. Investors still hold onto the investment because of its previous performance, waiting for the stock to get back to break-even. Investors may hang on to companies for years, when they should have been selling the laggard stock and redirecting their investment energies to other areas of the market, reinvesting recovered capital.
Anchoring can be also seen when investors listen to financial market media and act on the belief that there is some predictive quality to the information. The most potentially damaging to retail investors in recent times were the Brexit vote and negative media predictions about market outcomes of a Trump presidency. Retail investors who anchored and reacted to these types of stories by staying in cash, missed some of the best growth opportunities of 2016.
Saliency in finance is the tendency for an investor not to take action or ignore the potential for an event, merely due to the fact that this type of event has not occurred recently. If an event has not happened recently, there is a perception held that the likelihood of that event occurring is very small; e.g. sub- prime mortgage and events leading up to the GFC. On the other hand, if an event has occurred recently the reaction of an investor is often over-stated, e.g. staying cash for protracted periods of time after a correction in the market.
Herding behaviour is driven by a concept of social proofing. Social proofing is when people copy each other’s behaviour in an effort to fit in and reflect the correct group behaviour for a given set of circumstances. The so called correct behaviours could be defined by trend setters or guru figures, or people who are perceived to be “in the know”. Herding behaviour can be based on little or inaccurate information. Herding is when you feel the desire to sell a stock just because it is being given a lot of media attention or it could be just a negative opinion expressed by a friend. Investors work with the assumption that others have more information than they do, which influences herding behaviour. As the stock sells off, there is a strong emotional drive to do exactly what others are doing. To just sell because others are selling is not a rational basis for a decision. Investors are better off actively blocking out the “noise”, selecting stocks to buy carefully, and in time selling that stock for the right reasons.
Confirmation Basis is when investors go and look for only that information which supports their preconceived ideas surrounding a stock. Often they will accept all the positive information and ignore all the negative information. If for example they had a concentrated portfolio in financial stocks, often investors overemphasize positive information about the sector and ignore or at least discount negative information about the future expectation of stock performance.
Professional money managers are aware of cognitive biases. Retail investors are generally not. Making money is as much about the quality of decisions driven by cognitive biases as it is about building valuation models.
Take control- Keep on investing and know thyself!