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5 Cognitive Biases That Are Negatively Impacting Your Portfolio

Tyler Durden's picture




 

Submitted by Lance Roberts opf STA Wealth Management,

George Dvorsky once wrote that:

"The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn't mean our brains don't have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we're subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions."

Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money.  As history all too clearly shows, investors always do the "opposite" of what they should when it comes to investing their own money.  They "buy high" as the emotion of "greed" overtakes logic and "sell low" as "fear" impairs the decision making process.

Here are 5 of the most insidious biases that will keep you from achieving your long term investment goals.

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs.  If one believes that the stock market is going to rise, they tend to only seek out news and information that supports that position.  This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below.

Investor-Psychology-Cycle-041614

The issue of "confirmation bias" also creates a problem for the media. Since the media requires "paid advertisers" to create revenue, viewer or readership is paramount to obtaining those clients.  As financial markets are rising, presenting non-confirming views of the financial markets lowers views and reads as investors seek sources to "confirm" their current beliefs. Individuals want "affirmation" that they current thought process is correct.  As human beings, we hate being told that we are wrong, so we tend to seek out sources that tell us we are "right."

2) Gambler's Fallacy

The "Gambler's Fallacy" is one of the biggest issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.

"Past performance is no guarantee of future results."

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

This is one of the key issues that affect investor's long term returns.  Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next.  This is shown in the periodic table of returns below. "Hot hands" only tend to last on average 2-3 years before going "cold."

Periodic-Table-Returns-061714-2

I traced out the returns of the Russell 2000 for illustrative purposes but importantly you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. "Performance chasing" is a major detraction from investor's long term investment returns.

3) Probability Neglect

When it comes to "risk taking" there are two ways to assess the potential outcome. There are "possibilities" and "probabilities." As individual's we tend to lean toward what is possible such as playing the "lottery."  The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. However, it is the "possibility" of being fabulously wealthy that makes the lottery so successful as a "tax on poor people."

However, as investors we tend to neglect the "probabilities" of any given action which is specifically the statistical measure of "risk" undertaken with any given investment. As individuals, our bias is to "chase" stocks that have already shown the biggest increase in price as it is "possible" they could move even higher.  However, the "probability" is that most of the gains are likely already built into the current move and that a corrective action will occur first. 

Robert Rubin, former Secretary of the Treasury, once stated;

“As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.

 

Most people are in denial about uncertainty. They assume they're lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it's a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

Probability neglect is another major component to why investors consistently "buy high and sell low."

4) Herd Bias

Though we are often unconscious of the action, humans tend to "go with the crowd."  Much of this behavior relates back to "confirmation" of our decisions but also the need for acceptance. The thought process is rooted in the belief that if "everyone else" is doing something, they if I want to be accepted I need to do it too.

In life, "conforming" to the norm is socially accepted and in many ways expected.  However, in the financial markets the "herding" behavior is what drives market excesses during advances and declines.

As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that 'being too far ahead of your time is indistinguishable from being wrong.'

 

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian."

Moving against the "herd" is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to "bet" against the stampede.

5) Anchoring Effect

This is also known as a "relativity trap" which is the tendency for us to compare our current situation within our own limited experiences.  For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for.  However, can you tell me what exactly what you paid for your first bar of soap, your first hamburger or your first pair of shoes? Probably not.

The reason is that the purchase of the home was a major "life" event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and therefore we assume that the next home purchase will have a similar result.  We are mentally "anchored" to that event and base our future decisions around a very limited data.

When it comes to investing we do very much the same thing.  If we buy a stock and it goes up, we remember that event.  Therefore, we become anchored to that stock as opposed to one that lost value.  Individuals tend to "shun" stocks that lost value even if they were simply bought and sold at the wrong times due to investor error. After all, it is not "our" fault that the investment lost money; it was just a bad stock. Right?

This "anchoring" effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you "anchor" on ABC and keep buying it as it rises. When the stock begins its inevitable "reversion," investors remain "anchored" on past performance until the "pain of ownership" exceeds their emotional threshold. It is then that they panic "sell" and are now "anchored" to a negative experience and never buy shares of ABC again.


In the end, we are just human.  Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

Take a step back from the media and Wall Street commentary for a moment and make an honest assessment of the financial markets today. Does the current extension of the financial markets appear to be rational? Are individuals current assessing the "possibilities" or the "probabilities" in the markets?

As individuals, we are investing our hard earned "savings" into the Wall Street casino. Our job is to "bet" when the "odds" of winning are in our favor. With interest rates at abnormally low levels, inflation rising, economic data continuing the "muddle" through and the Federal Reserve extracting their support; exactly how "strong" is that hand you are betting on?

 

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Wed, 06/18/2014 - 17:04 | 4871103 bania
bania's picture

My golden bias hasnt been kind to me lately.

Wed, 06/18/2014 - 17:09 | 4871118 Da Yooper
Da Yooper's picture

That is due to #6

 

The banker & fed manipulation bias

 

which is the result of corupt bankers & US politicans

 

Wed, 06/18/2014 - 17:05 | 4871104 gh0atrider
gh0atrider's picture
1 Cognitive Biases That Are Negatively Impacting Your Portfolio:

 

Bitcoin is a fad that will soon blow over.

Wed, 06/18/2014 - 17:27 | 4871159 vie
vie's picture

That's the "Everything I don't understand is a tulip bubble" bias.  

Wed, 06/18/2014 - 18:01 | 4871243 Stoploss
Stoploss's picture

Well, it's clearly past the euphoria stage.

We're up in the WTF seats now...

Wed, 06/18/2014 - 18:05 | 4871262 CheapBastard
CheapBastard's picture

Ok, I understand all these Bi-Asses but stock prices and house prices always go up, right?

Wed, 06/18/2014 - 17:04 | 4871105 Dr Benway
Dr Benway's picture

"As individuals, we are investing our hard earned "savings" into the Wall Street casino."

 

Speak for yourself, motherfucker. And don't call a rigged game a "casino".

Wed, 06/18/2014 - 17:06 | 4871106 Squid Viscous
Squid Viscous's picture

you missed the part where S&P goes to 2000, probably by end of June

Wed, 06/18/2014 - 17:07 | 4871116 LawsofPhysics
LawsofPhysics's picture

optimist.

Wed, 06/18/2014 - 17:10 | 4871124 SheepDog-One
SheepDog-One's picture

2,000 by Friday probably.

Wed, 06/18/2014 - 17:08 | 4871109 SheepDog-One
SheepDog-One's picture

People emotionally connected to their portfolios will soon enough experience post partum depression.

Wed, 06/18/2014 - 17:08 | 4871112 LawsofPhysics
LawsofPhysics's picture

and that's why in the centrally-planned ZIRP (NIRP in real terms) world,  an "investor" with property or real assets that generate income or 3-5% returns, regardless of what equities are doing looks like a fucking genius...

FUBAR motherfuckers...

 

Wed, 06/18/2014 - 17:09 | 4871119 Cognitive Dissonance
Cognitive Dissonance's picture

"....exactly how "strong" is that hand you are betting on?"

I ain't betting on that hand so.......

The real question is....who in their right mind would play in a casino where the house, and those who control the house, run a rigged game?

The answer might lead you to your own cognitive dissonance.

Wed, 06/18/2014 - 17:12 | 4871131 SheepDog-One
SheepDog-One's picture

The Fed has a pair of 2'a, and a loaded double barrel shotgun under the table pointing at everyone's balls.

Wed, 06/18/2014 - 17:16 | 4871142 Cognitive Dissonance
Cognitive Dissonance's picture

And a pistol pointed at their own heads just in case the bluff don't work.

And ultimately it is a bluff.

Wed, 06/18/2014 - 18:07 | 4871273 CheapBastard
CheapBastard's picture

I remember my broker telling me back in 1999 there is no upper limit to how high internet stock prices will go. He predicted Lucent to 400, CSCO to 800 and so on.....He was a strong supporter of Enron also, I might add.

Wed, 06/18/2014 - 17:10 | 4871126 fonzannoon
fonzannoon's picture

After euphoria comes "calm as a buddha's ass" which pulls that chart up to infinity.

Give me a break with this. Who is "thrilled"? Who is "euphoric". This is not 1999 where everyone is comparing tech stocks. Everyone knows something is very very wrong but have (mostly) learned not to fight it.

Wed, 06/18/2014 - 17:20 | 4871154 Wait What
Wait What's picture

best comment today "very very wrong... learned not to fight it"

http://www.liveleak.com/view?i=d43_1369060192

Wed, 06/18/2014 - 17:17 | 4871144 Rainman
Rainman's picture

You warning is too late. Humans suffer from chronic emotional analysis leading to paralysis.

The Machines have no such problem.

Wed, 06/18/2014 - 17:17 | 4871145 oneshotklink
oneshotklink's picture

I overcome these biases with justifiable self-loathing.  This fuels a desire to get the outcome I deserve (losing my shirt in bad stocks), which causes me to do the exact opposite of what these biases would counsel, thereby making outsized returns.

Who says low self-esteem doesn't pay.

Wed, 06/18/2014 - 17:25 | 4871164 rosiescenario
rosiescenario's picture

AND....negating much of the information as portrayed by the charts is the 'survivorship bias' issue present in looking back on the S&P, DOW, etc.

Wed, 06/18/2014 - 17:28 | 4871170 HUGE_Gamma
HUGE_Gamma's picture

the chart is outdated.. we are at 1950.. whats next after the euphoria stage?

Wed, 06/18/2014 - 17:51 | 4871223 Groundhog Day
Groundhog Day's picture

Euphoria er comes next.  Spa 2100 fuch 2000

Wed, 06/18/2014 - 19:49 | 4871664 Emergency Ward
Emergency Ward's picture

The next stage is heavenly transcendence.

Wed, 06/18/2014 - 17:34 | 4871176 TabakLover
TabakLover's picture

"the Herd" is laughing their ass off reading this.

Wed, 06/18/2014 - 17:41 | 4871193 hazden
hazden's picture

Is the author suggesting that we're heading for a correction?  That his charts where he arbitrarily placed Emotion Tags backs this up?

Go back to the last time the S&P was at 1500.  Stick the Euphoria tag there, and bet on a crash. Oops, you lose.  Repeat this at 1600, 1700, 1800, 1900.  Oops, you lost every time.

Go ahead and keep fighting the Fed as the S&P blasts through 2000, 2100, etc.

Wed, 06/18/2014 - 17:44 | 4871200 Goldilocks
Goldilocks's picture

Conference on Inclusive Capitalism: Building Value, Renewing Trust
http://www.inclusivecapitalism.org/

~//~

yah got to keep 'em motivated...

The Offspring - Come Out and Play (Keep 'em Separated) HD
http://www.youtube.com/watch?v=PnHdpTpmAsY (3:14)

Wed, 06/18/2014 - 17:44 | 4871201 Dark Space
Dark Space's picture

Actually, what is described as the "Gambler's Fallacy" is not actually the "Gambler's Fallacy". The Gambler's Fallacy only applies to datasets with random results. In most markets (be it stocks, different fund managers, etc.) past results ARE indicative of future results because there are non-random causes such as a good CEO or a fund manager with a drinking problem or a central bank creating false supports to push all markets up, which are creating the results.

Wed, 06/18/2014 - 18:01 | 4871244 RaceToTheBottom
RaceToTheBottom's picture

Actually a better indicator of the emotions related to investing is the Movie Caddyshack.....

 

"I don't think the heavy stuff is going to come down for quite some time now."

Wed, 06/18/2014 - 18:06 | 4871251 Notsobadwlad
Notsobadwlad's picture

I get tired of these bullshit articles that tell the public that they are stupid for doing what is logical, ie. buy when sentiment is positive and sell when sentiment is negative.

People have been trained over the years that value matters. People try to buy value. People have been trained over the years that growth is OK, but only if it turns into value.

However, now we know for a fact based on the continuous stream of fraud that has occurred, that Wall Street is completely rigged and that stock prices are not at all determined by free market dynamics. If the market price was determined by free market dynamics then when sentiment was positive price would go up and when sentiment was negative price would go down.

What we now know is that the best way for Wall Street to STEAL money from people is to move price in the opposite direction of sentiment. Wall street specialists, market makers and HFT algos absolutely control price. The only way the specialists, market makers and algos make money is if the game is rigged. It is rigged because they get to SET PRICE and the public does not get to set price.

In reality, since the whole market is a rigged fraud scam, every single dollar that the banks and their market makers, specialists and HFT algos have taken from people under the false pretense that free market forces determine price, should be returned to the people that they stole the money from and then the responsible bankers and their trader cronies should all be put in jail.

But that is not how the world works. There are people in this world that completely depend on theft and fraud to make their parasitic living... and they are allowed to exist because they can accumulate a lot of money through theft and fraud and use that money to buy protection.

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