The efficient market hypothesis assumes that all humans are rational and act in their own self-interest. However, humans are often irrational and self-destructing, through no fault of their own other than being human. Earlier this week, we covered the first four of eight biases that we can be aware of and actively prevent them from harming our financial health. Here are final four predispositions of which we should be aware:
The act of avoiding loss is one us humans are prone to naturally. We are much more likely to cut our winners (in order to massage our ego that we were right) and be risk averse whereas with losers we will be risk seeking and run the loser, or add to it, perhaps even when the investment case is deteriorating.
Kahnemann and Taversky (1979) found that the pain of losing an amount is psychologically far greater, about twice as powerful, as winning the same amount. This explains why the free trial is so effective – it plays on the feeling of loss. It is also why penalties are far more motivating than rewards. Try it next time you need to motivate yourself, and you’ll see just how strong the feeling is.
To defeat loss aversion, we need to constantly train our brain to do what is unnatural. Going with the herd was once what was safe, and trusting your instincts got us out of danger of predators quickly, but in the investing world there are no place for such emotions.
Holding onto losers in the hope that they will eventually come good is psychologically draining. Knowing what can kill our investment thesis and constantly being on guard looking out for that catalyst will save us plenty of both physical and psychological capital.
This bias is the tendency for people to overestimate their ability to control themselves and resist impulsive investment decisions. Almost all of us think that we shouldn’t commit large portions of our capital to a single stock lest we put ourselves at risk financially, but all of us will know the feeling when we find a certain stock that we’re so sure it’s a winner, and we’re tempted to steam in with a large position.
The beauty of small and mid cap stocks is that if management do execute then there is plenty of upside. Rather than going all in at the start where the reward is highest (and also the risk), we should buy in small and add to our position once management begin to prove themselves. There is no rush and this allows us to follow the story objectively and let the investment case build strength and derisk itself.
The gambler’s fallacy is very similar to the Hot Hand fallacy – believing that previous investments have a connection to them. This happens when one believes that because they’d had five losers in a row, they’re now ‘due’ a winner. Unfortunately, the reality is that all events are interdependent of each other – even when trading in the same stock.
The market doesn’t care how many losers you’ve had, and the market doesn’t take into account a ‘hot hand’ either, which is when one believes that after a string of winning positions or trades that they’re on a ‘streak’.
Be aware that when we are at our most confident, that is when we are at our most vulnerable. The market will be ready to humble us in a big way should our egos get too big. Icarus, after all, flew far too close to the sun.
Sunk cost bias
Sunk cost is the notion of believing that after investing, we must continue to invest because we have already invested. To protect against sunk cost, we must ask ourselves if we would buy that same stock as the price it is now, if we didn’t hold it.
Sunk cost has been used to explain the endowment effect, but another effect of the sunk cost bias is that it prevents funds from being used elsewhere. Chasing a loser may mean missing out on a big winner!
The opportunity cost can be far in excess of the sunk costs already deployed, and though it can never be calculated, it only takes one big winner that we miss because we were laden with something we didn’t much want to hammer that point home.
To recap, here is a summary of the eight biases across this week’s two articles.
Anchoring bias – ignore the price we paid for our shares
Endowment bias – recognise that we are inherently placing a value higher than the market by the single virtue of us owning the stock
Information bias – be careful of market noise as it can lure us into action
Recency bias – collect information and clearly write down the investment case
Loss aversion – remember that every big loss started as a small loss; have a plan for when we are getting out
Restraint bias – instead of going in large at the start buy small and allow management to prove their worth to you
Gambler’s fallacy – the market doesn’t care about previous actions; previous actions are not linked
Sunk cost bias – we don’t need to be right, and if we wouldn’t buy at the current price if we didn’t own the stock, then we should think about cutting the loss
Author Michael Taylor’s website www.shiftingshares.com contains numerous tutorials on how to trade and invest as well as his free book – ‘How to Make Six Figures in Stocks’.