What Was I Thinking? – How Some Investment Decisions Are Made

Think about the last investment decision you made. Why did you make it?  Was it part of an existing investment strategy? Did you see somebody else do it? Perhaps it was done for you? 

This past month, I completed a course on behavioral finance, which is somewhat of a new field of study into the psychology of investing.  Among other things, it suggests that investors are predisposed to certain biases that influence the way they invest. These biases, in essence, can help explain why some investors do what they do when it comes to investing. See if you can identify with any of the following biases:

Hindsight bias

Have you ever watched something happen and think to yourself, “I knew that was going to happen”? It happened to me just last week. I watched a baseball player get thrown out at second base and I turned to my brother-in-law and said, “I knew he shouldn’t try to steal on the first pitch.”

It happens all the time. We see something happen and think to ourselves “I knew that was going to happen” when in reality we had no idea it was going to happen until it did, yet we trick ourselves into believing that we knew it the whole time.  Investors can easily get caught up into thinking they knew they were making a good investment decision, when in truth, they only realized it was a good decision after the fact.

What to do if you have this bias?

If you start talking about some great investment decision you’ve made, remember that it’s more likely a case of hindsight bias than a sign that you have a special gift.

Over-confidence bias

As the name suggests, an investor that suffers from this bias thinks he or she is better at choosing investments than most others—sort of a smartest-person-in-the-room mentality.  Back in 2000, I had a financial advisor tell me that when the NASDAQ hit 5,000 it was way overpriced and suggested that 2,500 was a more reasonable valuation. I ignored his warning and invested my Roth IRA in dot-com stocks because quite frankly, I thought I knew better.  This proved to be the worst investment decision I ever made.  Within a few months, the NASDAQ plummeted and in shame, I held on to my investments until they became practically worthless.

What to do if you have this bias?

Overconfidence leads to pride and as the biblical proverb suggests, pride comes before a fall.  If you find yourself questioning the wisdom of those around you then I suggest taking a timeout and watching a story about a little company called ENRON.

Familiarity bias

My colleagues and I work with several employer groups that offer company stock within their retirement plans.  It is not that unusual for us to come across an employee that has a concentrated position (more than 20%) invested in their own company. When asked, many will say something like “I know how well our company is doing,” but regardless of how well a company is doing, having a concentrated position is inherently risky.

This is an example of familiarity bias.  As investors, we like to invest in things we are familiar with.  That’s different than Warren Buffett’s invest-in-what-you-know rule.  Being familiar with a business because of their name and actually understanding what they do to support their stock price are two separate things. I am familiar with Apple by name but I have no idea what their business model looks like or how they plan to compete with their competition.

What to do if you have this bias?

Are you concentrated in company stock?  If so, consider divesting of your concentrated position.

Fear-of-regret bias

The very first stock I ever purchased was in an Australian company called Orbital Engine.  I invested $10,000 and within 12 months, the value of my position skyrocketed to $16,000.  Because I was convinced that it would go up even further, I held on to it and over the next several months, I watched as it fell from $16,000 to $2,000.  For the next several years, I continued to hold on to it, waiting for it to “come back.”

This is an example of fear-of-regret bias.  Investors that have this bias tend to hold on to declining investments because the act of selling an investment for a loss is dreadful.  Unfortunately, these investors may hold on to bad investments too long, suffering losses that may have been curbed had this bias not influenced them.

What to do if you have this bias?

If you have an investment that is down, take the overnight test.  If you are unwilling to buy the stock the next morning, it may be time to let it go.

These are just a few of the biases that affect the investment decisions we make.  Investors that understand and avoid them are more likely to see investment success over long periods of time. Will you?

 

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