Buy Right Sit Tight - 2018

Emotional Biases That Hurt Investor Returns – Part 1

By Amit Rupani

Temperament is very important in investing. Emotional stability and keen understanding of how human behavior works in the market dynamics are critical to long-term investment success. An emotion may be thought of as a mental state that arises spontaneously rather than through conscious effort. Most investors unknowingly suffer from emotional biases pushing them to making sub-optimal investment decisions.

In this article, I am sharing a few common emotional biases that all investors generally suffer from and ways to overcome them. Emotional biases are harder to correct as they originate from impulse rather than any conscious calculation. In the case of emotional biases, it may only be possible to recognize the bias and adapt to it rather than correct it.

Loss-aversion bias was identified by Daniel Kahneman and Amos Tversky in 1979. In loss-aversion bias people tend to strongly prefer avoiding losses as opposed to achieving gains. A number of studies on loss aversion suggest that, psychologically, losses are significantly more powerful than gains. When comparing absolute values, the utility derived from a gain is much lower than the utility given up with an equivalent loss.

Investors suffering from loss-aversion bias hold investments in a loss longer than justified by fundamentals hoping that prices will recover to break-even levels. They sell investments in gain position earlier than justified by fundamentals with the fear that their profits will erode. This limits their upside potential of the portfolio by selling winners and holding bad investments. In Peter Lynch's words, investors cut their flowers and water their weeds when they suffer from loss-aversion bias. The more rational approach is to take your loss, record the tax loss and move on to something that has better prospects.

A disciplined approach to investment based on fundamental analysis is a good way to alleviate the impact of the loss-aversion bias. If an investor is not averaging down but hoping for the position to return to break-even levels then the investor is just doing “hopeful investing." The bad news for hopeful investors is that stock market doesn't run based on hope but is based on logical fundamentals. It is impossible to make experiencing losses any less painful emotionally, but analyzing investments and realistically considering the probabilities of future losses and gains may help investor to take a rational decision.

Overconfidence bias is where people demonstrate unwarranted faith in their own intuitive reasoning and judgments. While confidence can be beneficial, overconfidence is often detrimental in investing. Confidence can easily turn into overconfidence after a few easy wins. This overconfidence may be the result of overestimating knowledge levels, abilities, and access to information.

Investors suffering from overconfidence bias underestimate risks and overestimate expected returns. Hold poorly diversified portfolios (all eggs in one basket) and trade excessively to experience lower return than market return. Buy risky investments because they believe they aren't really risky.

It is very critical to know what is actually knowable, and to make peace with the factors you can't know. Investors should resist the urge to believe that their “gut feeling" has higher probability of success if the data sample size is small and there are many dependencies driving the end outcome. It is a good idea to perform post-investment analysis on both successful and unsuccessful investments. Dissect whether overconfidence bias was exhibited and create mental rules so that same mistakes are not repeated again in future.

Self-control bias is a bias in which people fail to act in pursuit of their long-term, overarching goals because of a lack of self-discipline. There is an inherent conflict between short-term satisfaction and achievement of some long-term goals. Many people are notorious for displaying a lack of self-control when it comes to money. Self-control bias can cause investors to spend more today at the expense of saving for tomorrow. It may cause investors to fail to plan for retirement. Self-control bias can cause asset-allocation imbalance problem and can also cause investors to lose sight of basic financial principles, such as compounding of interest, dollar cost averaging, and similar discipline behaviors that, if adhered to, can help create significant long-term wealth. The benefits of self-discipline in investing are difficult to obtain. The results, however, are well worth it.

Money is not the only area where people displaying lack of self-control. Attitudes toward eating and smoking provide other examples. An overweight person is told by a doctor that weight loss is essential to long-term good health. Still the individual may fail to cut back on food consumption. Similarly, smokers may continue to smoke even though they are aware of the long-term health risks involved. Such behavior leads to short-term utility but disastrous long-term utility.

Investing without planning is like building without a blueprint. Planning is key to achieving long-term financial goals which should be in written format and reviewed regularly. Failing to plan is planning to fail. A smart budget coupled with proper asset allocation shall balance both today's satisfaction and tomorrow's contentment to attain long-term financial success.

I will share more emotional biases in Saathee's October edition. Happy investing!

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com