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Hudson Financial Planning - Behavioural Biases Revisited

Behavioural Biases Revisited

Both myself and other advisers here have written about behavioural biases when it comes to investing and it remains a fascinating subject to me, mainly because they continue to exist, and even if you know about them can still find yourself victim to them, since they are generally in our nature, and a leopard cannot change it’s spots.

Today I am going to focus on two biases in particular and if you are (or have been) a keen investor I am confident you may find yourself admitting to having had these experiences before.

Hindsight bias

It is very common for people to look back on an event and convince themselves the outcome was obvious and “bound” to happen … they should have known! I have had several Hudson members ask me why we did not warn them about the GFC and how if you look on a graph showing, say the All Ordinaries, that surely it was going too high, too fast, and was bound for a huge correction? Incorrect.

It is in our nature to want to create order, and create explanations to make sense of events, rather than admit that things can be unpredictable and out of our control or estimation. We want to look back and say that was the cause, and that was the effect. Excellent, now I have learned from my mistake and will not get duped again. This can work well in some fields, such as mathematics, where you are usually able to find a link to connect A to B and explain a phenomenon or process.

But share market investing? Not so easy. There are simply too many variables, including such things as sentiment, which incorporates the entire spectrum of human emotion (fear, greed, etc), and as such it IS possible to large-scale unexplainable events. Was the share market undervalued in February 2009? I’d say absolutely it was. But that didn’t stop the biggest market movement during the entire GFC period occurring in March 2009 involving a move from equities to cash. The GFC occurred, there is no getting around that, but it was not inevitable. And it may be fair to say the market was overvalued and due for correction. However the point is that other possibilities could have occurred, a slower fall over a longer period for example, or perhaps the markets just flat-lining and staying steady for several years.

So how might hindsight be affecting your decisions right now? You may be giving yourself a false sense of security for your current decisions, by over-estimating the accuracy of your previous forecasts. Example, you buy stock A and three months later you have made a tidy profit. You then start looking at stock B and also believe this may have potential. There is a natural (and proven) inclination to be overly confident on stock B, BECAUSE of the success you had with Stock A.

How to avoid it? You have taken the first step by reading my article; awareness of it can help prevent it. Next step, as always, TRY TO REMAIN UNBIASED. Look at the facts of the stock, the black and white. Balance the risk and return (i.e. the more speculative, the less you should invest).

My final thought. The parallels that share investing have to gambling always astound me. People holding on to a share just because it has done well so far for them are akin to a punter saying, “I’m on a roll, I shouldn’t quit now”. Conversely an investor that keeps a stock just because it’s been underperforming for so long is akin to a punter saying, “I’ve lost so many bets in a row, I must be due for a win”! Focus only on the cold hard facts, the fundamentals of the company, and the current conditions surrounding their own structure, and that of their industry and marketplace.

The disposition effect

This is a phrase coined by two academics Shefrin & Statmen who studied the behaviour whereby investors instinctively SELL stocks that have made a gain and HOLD stocks that have made a loss. As a result of this, an investor will often lose out on an asset that continues to rise after they sell, and likewise hold on to a stock that may never return to a previous value.

Keep doing that, and eventually you will have nothing but underperforming stocks!

NOTE: I am not saying you should always hold stocks that have gained and always sell those that have lost, as always, I am saying you should look to the fundamentals of the company, not to the history.

Why do people have a bias to sell rising stocks? They see the gain and want to lock it in, often disregarding future potential. This provides validation for their decision, and a story to tell their mates down the pub. The trouble is that it is effectively trying to “pick the top”.

Why do people have a bias to keep losing stocks? Again, it can be a form of validation, and possibly a form of stubbornness. Through frustration and disappointment, investors often hold a poor stock in the hope they will one day be proved right. The trouble is that there may be an OPPORTUNITY COST of an alternate investment you are missing out on.

My final thought: As hard as it is, you should not be MORE tempted to realise a gain, than you are to realise a loss. This is difficult because realising a gain means money in the bank, where holding a losing stock seems to be just a “paper loss”, and the investor thinks they will just hold out until they break even. In reality, if the stock never returns that paper loss eventually becomes real regardless.

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