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10 cognitive biases that can lead to investment mistakes (Part 2)

To be a successful investor over the long term, it is critical to understand, and hopefully overcome, common human cognitive or psychological biases that often lead to poor decisions and investment mistakes. Cognitive biases are ‘hard wired’ and we are all liable to take shortcuts, oversimplify complex decisions and be overconfident in our decision-making process. Understanding our cognitive biases can lead to better decision making, which is fundamental to lowering risk and improving investment returns over time.

Over two articles, I outline 10 key cognitive biases that can lead to poor investment decisions. The first five biases of confirmation, information, loss aversion, incentive-caused, and oversimplification tendency were discussed in part 1. Here are the remaining five:

6. Hindsight bias

Hindsight bias is a tendency to see beneficial past events as predictable and bad events as not predictable. In recent years, we have read many explanations for poor investment performance that blame the unpredictability and volatility of markets. Some of the explanations are as credible as a school child complaining to the teacher that ‘the dog ate my homework’. While we have made mistakes, we will not blame our mistakes on so-called unpredictable events. In fact, every mistake we have made over the past five years could be attributed to an error of judgment. We have always sought to candidly outline our investment mistakes in our Investor Letters.

Hindsight bias clouds objectivity in assessing past investment decisions and inhibits ability to learn from past mistakes. To reduce hindsight bias, we spend significant time upfront setting out in writing the investment case for each stock, including our estimated return. This makes it more difficult to ‘rewrite’ our investment history with the benefit of hindsight. We do this for individual stock investments and macroeconomic calls.

7. Bandwagon effect (or groupthink)

The bandwagon effect, or groupthink, describes gaining comfort because many other people do (or believe) the same. Buffett tells a story about the oil prospector who dies and is in a large crowd of other oil prospectors who are all waiting at the gates of heaven. All of a sudden, the crowd disperses. Saint Peter asks the oil prospector why the crowd dispersed. The oil prospector said it was simple: “I shouted, ‘Oil discovered in hell.’” Saint Peter asks the oil prospector why he would like to be let into heaven. After thinking for a while the oil prospector says, “I think I will go and join my colleagues as there may be some truth in that rumour after all.”

To be a successful investor, you must analyse and think independently. Speculative bubbles are typically the result of groupthink and herd mentality. We find no comfort in the fact that other people are doing certain things or whether people agree with us. We will be right or wrong because our analysis and judgement is either right or wrong.

In avoiding the pitfalls of the bandwagon effect, I am reminded of the Robert Frost poem, The Road Not Taken, where he writes:

“Two roads diverged in a wood and I,
I took the one less travelled by,
And that has made all the difference.”

While we don’t seek to be contrarian, we have no hesitation in taking ‘the road less travelled’ if that is what our analysis concludes.

8. Restraint bias

Restraint bias is the tendency to overestimate one’s ability to show restraint in the face of temptation. This is most often associated with eating disorders. Most people are wired to be ‘greedy’ and want more of a good thing or a ‘sure winner’. For many people, money is the ultimate temptation. The issue is how to properly size an investment when they believe they have identified a ‘sure winner’. Many investors have come unstuck by overindulging in their ‘best investment ideas’. ‘Sure thing’ investments are exceptionally rare and many investments are sensitive to changes in assumptions, particularly macroeconomic assumptions.

To overcome our natural tendency to buy more and more of our best ideas, we hardwire into our process restraints or risk controls that place maximum limitations on stocks and combinations of stocks that we consider carry aggregation risk. The benefit of risk controls to mitigate the human tendency for greed is well captured by the quote from Oscar Wilde: “I can resist everything except temptation.”

9. Neglect of probability

Humans tend to ignore or over- or underestimate probability in decision making. Most people are inclined to oversimplify and assume a single point estimate when making investment decisions. The reality is that the outcome an investor has in mind is their best or most probable estimate. Around this outcome is a distribution of possible outcomes, known as the distribution curve. The shape of the distribution curve of possible valuation outcomes can vary dramatically depending on the nature and competitive strength of an individual business.

Businesses that are more mature, less subject to economic cycles and have particularly strong competitive positions (examples would include Coca-Cola and Nestlé) tend to have a tighter distribution of valuation outcomes than businesses that are less mature or more subject to economic cycles or competitive forces. Examples in our portfolio include Wells Fargo, eBay and Alphabet (the owner of Google). In our portfolio-construction process, we distinguish between different businesses to account for the different risks or probabilities of outcomes.

Another error investors make is to overestimate or misprice the risk of very low probability events. That does not mean that ‘black swan’ events won’t occur but overcompensating for very low probability events can be costly. We seek to mitigate the risk of black swan events by including in the portfolio a meaningful proportion of businesses (purchased at appropriate prices) where we believe the distribution curve of valuation outcomes is particularly tight. We term these businesses as high-quality long-cycle businesses. We believe the risk of a permanent capital loss from a black swan event in this part of the portfolio is low. If we have real insight that the probability of a black swan event is materially increasing and the pricing is attractive enough to reduce this risk, we will have no hesitation in making a change to the portfolio, particularly our holdings of shorter-cycle businesses. The issue for investors is assessing when the probability of such an event is materially increasing. It is usually not correlated with the amount of press or market coverage on a particular event. Buffett once said: “The worst mistake you can make in stocks is to buy or sell stocks based on current headlines.”

10. Anchoring bias

Anchoring bias is the tendency to rely too heavily on, or anchor to, a past reference or one piece of information when making a decision. There have been many academic studies undertaken on the power of anchoring on decision making. Studies typically get people to focus on a totally random number, like their year of birth or age, before being asked to assign a value to something. The studies show that people are influenced in their answer, or anchored, to the random number that they have focused on prior to being asked the question.

From an investment perspective, one obvious anchor is the recent share price. Many people base their investment decisions on the current share price relative to its trading history. In fact, there is an investment school of thought (called technical analysis, an amusing term in itself) that bases investing on charting share prices. Unfortunately, where a share price has been in the past presents no information as to whether a stock is cheap or expensive. We base our investment decisions on whether the share price is trading at a discount to our assessment of intrinsic value and we have no regard as to where the share price has been in the past. We also have little regard to the prevailing share price in deciding to invest the time to research a new investment opportunity. Share prices change and we want to have a range of well-researched investment opportunities so that we can act on an informed basis when prices move below our assessment of intrinsic value.

 

Hamish Douglass is Chief Executive Officer, Chief Investment Officer and Lead Portfolio Manager at Magellan Asset Management. Magellan is a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual.

 

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