Beliefs that make you stick with bad investment decisions

Behavioural finance: belief perseverance

Dear Investors,

No one is a natural-born investor. When you start investing you make mistakes. The more you learn about investing, the more you realise that your natural instincts can lead you astray.

Behavioural finance is about understanding those mistakes and avoiding them. So this week, we begin a three-part look at behavioural finance. The first two parts will be on cognitive errors (faulty reasoning) and the last part will be on emotional biases (feelings).

These are some of the most important things you can use to improve your investment results.

Sincerely, Raj

Today, we are going to look at cognitive errors. They affect your investment results by subtly and unconsciously moving your behaviour away from something that distresses you, to something that pleases you.

This week we will look at belief perseverance biases. These beliefs make you want to stick with bad investment decisions:

  • Conservatism bias

  • Confirmation bias

  • Representative bias

  • Illusion of control

  • Hindsight bias

Conservatism bias

Conservatism bias occurs when people refuse to change their mind. They hold on to a previous opinion and do not consider new information. Normally this affects your investments because you are slow to update to new information and therefore hold onto an investment too long.

The best way to avoid this bias is to become aware of your mental biases.

Confirmation bias

Confirmation bias occurs when people look for information to support an existing view. This happens all the time in investing. I’ve seen it in action in private equity teams who are keen on doing a deal. They keep looking for information that makes the business case. The same is true for stocks you want to own. You find reasons to own them.

The best way to avoid this bias is to look for information that is contrary to your opinion.

Representative bias

Representative bias occurs when people use simple decision rules instead of doing thorough analysis. For instance, if a stock is considered a growth stock, it continues to be evaluated as a growth stock even if information indicates otherwise.

To an extent, we might be experiencing this in the US tech stock sector. For years, tech stocks (e.g. Apple, Google, Microsoft, Amazon, Facebook, etc) have been the darlings of the market. People continue to invest heavily in these stocks. But are these stocks still the growth stocks of tomorrow?

The best way to avoid this bias is to understand probability and statistics (But honestly, who is going to do that?).

A good starting point might be to look at base-rates. These are the probabilities of things happening. For instance, instead of looking at the latest skyrocketing returns for a company, look at the company’s returns over time. Then decide if it is likely that the current high returns will continue in future. In this way, you do not give new information too high a weighting and instead look at what the statistics tell you.

Illusion of control

Illusion of control is where people believe that they can affect outcomes, which they cannot. This bias can result in investors mistakenly being overconfident in their analyses.

The best way to avoid this bias is to understand that investment results have an element of probability. So the investor should look for opposing viewpoints and keep written documents on the thinking behind investment ideas.

Hindsight bias

Hindsight bias is being selective in remembering past events. Investors tend to remember their correct opinions. They forget the wrong ones. They also overestimate what was knowable at the time.

This can lead to investors believing that they get things right more often than they actually do.

The best way to avoid this bias is to keep investment records and review them.

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