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10 cognitive biases that can lead to investment mistakes (part 1)

To be a successful investor over the long term, we believe 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 are as follows:

1. Confirmation bias

Confirmation bias is the natural human tendency to seek or emphasise information that confirms an existing conclusion or hypothesis. Confirmation bias is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong.

To minimise the risk of confirmation bias, we attempt to challenge the status quo and seek information that causes us to question our investment thesis. In fact, we are always seeking to ‘invert’ the investment case to analyse why we might be wrong. We continually revisit our investment case and challenge our assumptions. It is much more important to ask yourself why you are wrong than why you are right. Charlie Munger, the Vice Chairman of Berkshire Hathaway and Warren Buffett’s business partner, said:

“Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”

The strength of many of history’s most accomplished scientists and mathematicians has been their ability to overcome their confirmation bias and to see all sides of a problem. Carl Jacobi, the famous 19th century mathematician, said: “Invert, always invert.”

2. Information bias

Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. The key in investing is to see the ‘wood from the trees’ and to carefully evaluate information that is relevant to making a more informed investment decision and to discard (and hopefully ignore) irrelevant information. Investors are bombarded with useless information every day, from financial commentators, newspapers and stockbrokers, and it is difficult to filter through it to focus on information that is relevant. In our view, daily share price or market movements usually contain no information that is relevant to an investor who is concerned about the medium-term prospects for an investment, yet there are entire news shows and financial columns dedicated to evaluating movements in share prices on a moment-by-moment basis. In many instances, investors will make investment decisions to buy or sell an investment on the basis of short-term movements in the share price. This can cause investors to sell wonderful investments due to the fact that the share price has fallen and to buy into bad investments on the basis that the share price has risen.

In general, investors would make superior investment decisions if they ignored daily share-price movements and focused on the medium-term prospects for the underlying investment and looked at the price in comparison to those prospects. By ignoring daily commentary regarding share prices, investors would overcome a dangerous source of information bias in the investment decision-making process.

3. Loss aversion/endowment effect

Loss aversion is the tendency to strongly prefer avoiding losses than obtaining gains. Closely related to loss aversion is the endowment effect, which occurs when people place a higher value on a good that they own than on an identical good that they do not own. The loss aversion/endowment effect can lead to very poor and irrational investment decisions whereby investors refuse to sell loss-making investments in the hope of making their money back.

The loss-aversion tendency breaks one of the cardinal rules of economics; the measurement of opportunity cost. To be a successful investor over time you must be able to properly measure opportunity cost and not be anchored to past investment decisions due to the inbuilt human tendency to avoid losses. Investors who become anchored due to loss aversion will pass on mouth-watering investment opportunities to retain an existing loss-making investment in the hope of making their money back.

All past decisions are sunk costs and a decision to retain or sell an existing investment must be measured against its opportunity cost. To increase our focus on measuring opportunity cost, we run the Magellan Global Fund like a ‘football team’ where we have the ability to put about 25 players onto the paddock at any one time. This forces us to focus on the opportunity cost of retaining an existing investment versus making a new investment in the portfolio. We believe many investors would make superior investment decisions if they constrained the number of investments in their portfolios as they would be forced to measure opportunity cost and make choices between investments. Buffett often gives the illustration that investors would achieve superior investment results over the long term if they had an imaginary ‘punch card’ with space for only 20 holes and every time they made an investment during their lifetime they had to punch the card. In Buffett’s view, this would force investors to think very carefully about the investment, including the risks, which would lead to more informed investment decisions.

4. Incentive-caused bias

Incentive-caused bias is the power that rewards and incentives can have on human behaviour, often leading to folly. The sub-prime housing crisis in the US is a classic case study in incentive-caused bias. Notwithstanding that financiers knew that they were lending money to borrowers with appalling credit histories, and in many cases people with no incomes or jobs and limited assets (‘NINJA’ loans), an entire industry, with intelligent people, was built on lending to such people.

How did this happen on such a massive scale? We believe the answer can be found in the effect of incentives.

At virtually every level of the value chain, there were incentives in place to encourage people to participate. The developers had strong incentive to construct new houses. The mortgage brokers had strong incentive to find people to take out mortgages. The investment banks had a big incentive to pay mortgage brokers to originate loans so that they could package and securitise these loans to sell to investors. The ratings agencies had strong incentive to give AAA ratings to mortgage securities to generate fees, and banks had a big incentive to buy these AAA-rated mortgage securities as they required little capital and produced enormous, leveraged profits.

Buffett said:

“Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

One of the key factors we focus on in making investment decisions is our evaluation of agency risk. We evaluate the incentives and rewards systems in place to assess whether they are likely to encourage management to make rational long-term decisions. We prefer companies that have incentive schemes that focus management on the downside as well as the upside and encourage management to return excess cash to shareholders. For instance, executive compensation that is overly skewed towards share-option schemes can encourage behaviour that is contrary to the long-term interests of shareholders, such as retention of earnings above those that can be usefully reinvested into the business.

5. Oversimplification tendency

In seeking to understand complex matters humans tend to want clear and simple explanations. Unfortunately, some matters are inherently complex or uncertain and do not lend themselves to simple explanations. In fact, some matters are so uncertain that it is not possible to see the future with any clarity. In our view, many investment mistakes are made when people oversimplify uncertain or complex matters.

Albert Einstein said: “Make things as simple as possible, but no more simple.”

A key to successful investing is to stay within your ‘circle of competence’. A key part of our ‘circle of competence’ is to concentrate our investments in areas that exhibit a high degree of predictability and to be wary of areas that are highly complex and/or highly uncertain. We believe that forecasting the volume growth for Colgate-Palmolive, Coca-Cola or Procter & Gamble is relatively foreseeable over the next 10 years and is well within our circle of competence. Investing in financials is far more complex and we are disciplined to try to ensure we do not overly simplify the inherent complexity of a major financial institution. If we cannot understand the complexity of a financial institution, we simply will not invest, no matter how compelling the ‘simplified’ investment case may appear. Notwithstanding that our investment team has over 50 years of combined experience in analysing financial institutions, there are many institutions that we believe are simply too difficult to assess.

In our view, the majority of the investment mistakes we have made can in large part be attributed to our cognitive biases, where we have fallen susceptible to confirmation bias, have oversimplified a complex problem or strayed outside our circle of competence. Unfortunately, these cognitive biases are ‘hard wired’ and we will make mistakes in the future. Our aim is to have systems and processes in place that minimise the number of mistakes we will inevitably make due to our cognitive biases.

Part 2

The remaining five cognitive biases of hindsight, the bandwagon effect, restraint, neglect of probability, and anchoring are covered in the second article.

 

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.

 

7 Comments
Warren Bird
June 17, 2017

It actually is insider trading. If you come into possession of information that you think will influence the price of a share once the information becomes more widely known, or if you hear of a pending action that will influence the price before the action takes place, then you have broken the law if you trade on that information.

A lot of you will react to this by saying, 'no way'. But when we had seminars on this topic from our corporate lawyers at Colonial First State 15-20 years ago they made it quite clear that this sort of thing was a very clear example of insider trading.

People in this industry really need to be clear on the laws under which we operate. Perhaps Cuffelinks could get a financial lawyer to write an article about this some time.

David
June 17, 2017

Another Buffett story. Taxiing around Omaha I was asking the drivers about their portfolios, until one told me quite reasonably that was his business. The scenario; suits arrive from the big smoke to see the great man and talk excitedly in the taxi about their proposition, ignoring the presence of a third party, some dumb cab driver. Or even better leaving and even more excitedly talking about what his backing is going to mean for their company. So I figure those dumb taxi drivers must be the wealthiest in the world. You could hardly call it insider trading.
All the best
David

Chris
June 19, 2017

Until they start giving you stock tips, then you know it's time to sell everything because it's at the top of the market...

David
June 16, 2017

You are obviously strong on Warren Buffett (as are most of us). Reading the psychological biases reminds me of our one trip to the Berkshire Hathaway AGM. If you haven’t been it goes like this:
3 or 4 minutes for the formalities and then several hours of Warren (everybody call him Warren, or occasionally Mr Buffett, not chairman) and Charlie taking questions from 20,000 or so adoring fans (and rightly so. He has made them wealthy).
There’s at least an hour of stories out of just one meeting but here is one which relates to the Hamish article:
Shareholder: Warren, we hear about your successes but tell us about your failures.
WB: that one’s too hard for me so I’ll pass it to Charlie.
CM: well let me see …pause… I can’t offhand think of any failures in what we HAVE done, but can think of several arising from opportunities which we HAVE NOT taken up……..thus the loss aversion error even at that level.

On the quality selection issue:
You wouldn’t know, unless I’ve mentioned it before, that over the last 25 years I have been involved in almost 60 startups, two of which have been unicorns, thus swamping all the complete failures (about half). Of the dozen or so currently extant one will definitely be a unicorn (after four year starting from nothing it is already about halfway and if listed or sold would probably get there now) and another has a good chance. But from discussion with Daniel Petre (recognised by many of us as the star in our small pond) he has a spectacularly higher success. Why? Although he is undeniably highly intelligent (which doesn’t hurt) my view is it is because of his highly regimented and detailed approach to opportunities. No magic. By comparison I’m downright slapdash.

Finally, please pass on my congratulations to Chris – well done.

Regards and please keep up your first class standard.

David

Warren Bird
June 16, 2017

Yes. Behavioural Finance 1.01, but it's easy to forget these things.

Mark Fenech
June 16, 2017

Nice to see Hamish reiterate the human cognitive or psychological biases raised by Charlie Munger over the decades available in his book Poor Charlie's Almanack.

Ryan
June 15, 2017

Great article. Found myself nodding as I recognised many of these biases in my own thinking.

I am looking forward to part 2.

 

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