Successful investors understand their own biases before making investment decisions.
Like all decisions people make, investment decisions are influenced by personal biases. This is a risk for investors because biased decisions are not objective. That’s why it is crucial to look within before looking at the market. To identify and manage biases before making investment decisions. As Aristotle observed, “Knowing yourself is the beginning of all wisdom.”
Identifying investment bias
Investment biases come in a multitude of flavours. Loss aversion is one most of us suffer from. Simply put, investors are more emotionally affected by gains than losses. So they hold onto bad investments for too long, hoping to recoup losses over time. On the flip side, they sell winning investments too quickly, hoping to concretise short term gains. Professors Shefrin and Statman call this the “disposition effect” – investors sell winning investments too early and hold onto poor investments for too long.
Other common investment biases include:
- Confirmation bias – where investors are drawn to facts that validate pre-conceived beliefs. For example, an investor wanting to buy shares in a technology company will give more weight to stories about new product development than concerns about increased competition.
- Familiarity – perhaps best exemplified by the tendency to concentrate investment in a person’s home country – which creates a lack of diversity in their portfolio
- Herding – where investors follow the behaviours of others for fear of missing out. The “dot-com” boom and bust of the late 1990s is a classic example of investors following others in a frenzied rush to buy (and sell!)
- Overconfidence – investing based on a successful previous investment. For example, US property investors who assumed that “property always goes up” only to be caught by the sub-prime property crash.
- Choice paralysis – resulting from too many investment options. In a well-known study, researchers set up a jam tasting booth in a supermarket. When a choice of six jams was presented, 30 per cent of people who sampled them made a purchase. When this was increased to 24 varieties, only three per cent bought something
These kinds of biases are part of the human decision making process. Unfortunately there is no cure, but investors with an awareness of their biases are less likely to make mistakes because of them. That’s also one reason why professional investors can outperform “amateurs” – they are more aware of the very human biases at play and can institute systems and disciplines to counteract them. One of those key disciplines is a rigorous approach to valuation.
Don’t pay the wrong price
Once you focus on the value of an asset (is the intrinsic value reflected in the current price?) – you have a benchmark on which to base investment decisions. That in turn allows you beat the fear and greed implicit in many investment biases and avoid rushing decisions.
A focus on value gives you a logical reason to buy or sell an asset – and an objective measure of when to do it. Investing is a process that shouldn’t be rushed. As Warren Buffett quipped, “You can’t produce a baby in one month by getting nine women pregnant.”
Successful investment is a long term game based on a mix of patience and value. The launch of the Perpetual Equity Investment Company illustrates the point. After raising more than $250 million in the biggest listing of its type since the Global Financial Crisis, there was some market pressure to put the capital to work straight away. Yet the Portfolio Manager, Vince Pezzullo, retained a large cash balance until the opportunity to buy his preferred assets at better value occurred during a period of market volatility.
Patience is an investor’s friend because it is crucial to finding real value. It may also be the most powerful antidote to biased decision making.
Watch Perpetual’s investment experts for more insight into the importance of patience and value.
This article is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in this article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.