Behavior (Psychology)

let’s start with a scenario to build the context …

say you have some money to invest in stock market and since you are a smart person and lots of information is available on your broker’s website or otherwise on internet, you decided to do some analysis and based your analysis you find that the apple stock would be a good buy at $100, so you called your broker or went through his website and bought apple stocks & feel good about it .. piece of apple .. builds dopamine in your head .. right ? 

in a few days, you hear a bad news about apple … & since you are your own analyst, the question arises, would you ignore the news, thinking this is no big deal & will pass, since you did a perfect analysis OR would you deal with this bad news with same intensity as you did your initial analysis  ..?

separately, if you hear a good news about apple, would you read it till end to find any caveats or just the headline & feel better ..?  … as it not only justifies your decisions, but also brings more dopamine to your head .. this is called confirmation bias; i.e. the moment you buy a single stock of apple, you become biased with your decision and look for information only that supports your decision and ignore the one against.

now let’s say the stock goes down to $95 .. & you have some more capital to invest .. would you redo your analysis with the same vigor, as you did last time, whether a $95 is a good price to buy OR would you simply do a quick calculations in your head that since it was a good buy at $100, it must be a better buy at $95 ..  plus, it will reduce your cost basis (also known as dollar cost averaging) rather than thinking in reverse that if your analysis was right, why it’s selling at $95 now … this is called anchoring bias; i.e. you take new decisions based in the context of your past decisions & ignore new information which is not favorable to your decision. 

alternately, if you do your research with same intensity, are you open to a possibility that the situation has changed such that apple now is a sell at $95 rather than a buy, so take some loss and close an existing [long] position … think about it.

what’s an investment bias ..?

when you look at the picture on your right .. what does your mind do ..? 

for most people, it’s to find which line is bigger or smaller ..? but, why would you do that? … because right at the first look you mind has already made a decision that they are not equal; hence one of them is bigger than the other ..!

the question is how does the mind make a decision first …  well, that’s the key .. you mind tells your eyes what to see based on a preconceived conclusion and your eyes see exactly what your mind tells them to see ..  in investment world, this is called investment bias …

an investment bias in general means that a person’s opinion about a stock / stock market is simply a reflection of his current position/ portfolio  ..  for example, your reaction to a news item or any new information depends on whether you have: 

1. no position in your portfolio (all cash, no gains or losses); ideal situation, as you are not biased 

2. your positions are in the money (gains); you mind will discard/take lightly any negative information and weigh-in positive information strongly

3. your positions are out of money (i.e. in losses); & therefore, you will ignore that a [bad] situation that caused your position to be in loss is becoming worse 

you mind tricks you and reacts to new information based on the state of current portfolio OR, in other words … “your eyes see only what your brain wants them to see” … count the number of times it takes you to convince your own mind that the two lines on the right are of same size …  conclusion: “most people make a decision first and then look for data to support their decision”  

OR, in other words, “it’s not about the observed, but about the observer.”

let me give you an example using Warren Buffett, as i am his biggest fan as well as critic .. when was the last time you heard Buffett saying that stock market is frothy and hence people should sell .. NEVER …!

why ..?  since he only holds long positions in US companies .. he is simply biased (& justifiably because that’s his job!) with the market that he believes in the strengths of USA & therefore, the stock market will continue to go up in long-time; still, these long-terms have had 50% drops, but he will never says that market is high because of his own bias (or in this case his job)!  i.e. if you have invested $100B+ in companies, would you come out and say; hey .. market is way too high and so i should be selling, but i am not ..!

Human risk taking capacity varies with situation …

humans risk taking capacity changes with the situation are in … so a static risk profile as prepared/calculated by your broker based on the answers to a typical questionnaire is a bogus thing  … 

let me explain .. if you make a stock purchase and the position has gains … unless you are a sophisticated investor/trader & you are able to manage your emotions, you will be keen in closing the position and taking the gains; i.e. your risk capacity is based on the state of your position – makes sense … now consider an opposite case, you have a position and it turns into a loss, you will be inclined to hold it for longer duration (than in above case) hoping that it will at least breakeven, even though you watch it going down (in more losses) everyday .. so, your risk capacity is dynamic and it depends on whether you have gains or losses in your portfolio.

bias  /ˈbīəs/
noun:  prejudice in favor of or against one thing, person, or group compared  with another, usually in a way considered to be unfair.
verb: cause to feel or show inclination or prejudice for or against someone or something.

“simply a tendency to take action based on feeling rather than fact” …  a VIP definition, which is a normal human behavior, but not rational.

here, i am describing the textbook definitions of various biases found in the  life of an investor, along with my own experiences with them … how i  was hit in various situations during my 20 years investment journey ..?  … and how i recovered from each one of them … you may have to discover your own solutions based on your situation … so, here we go:

confirmation bias

humans tend to selectively filter first impressions, as they can be hard to shake, paying more attention to information that supports our opinions while ignoring the rest … we often resort to preconceived opinions when encountering something new … an investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her idea about an investment rather than seek out information that contradicts it. 

the above is a textbook definition, but let me try to explain this with an  example: let’s say you were talking to your friend who is bragging about how he made ton of money in apple stock (mid 2013 – mid 2015) and convinced you that APPL is still a good buy (since he is still long) … you got convinced and bought the stock next day … then in next few weeks, you discovered something bad about APPL which makes you think  that the stock can go down … now try convincing yourself to sell your APPL position.

see how easy it is ..? … well, it’s NOT … in fact, it is really hard to  convince yourself or someone else that APPL is a sell when you already  own it, especially when you recently bought the stock … moreover, your friend, Ramlal – the bragger, can make money from it and you can’t …  btw, on surface, it looks like a stupid behavior, why one would not sell a stock, when you are sure it will go down, something you got to try it to experience it. 

another example: most of you have equity funds in your 401K portfolio … & the interesting thing is that it is NOT possible either to short or hedge in a 401K account .. possibly in IRA account, but it depends on the broker … which means most of you are long in your retirement portfolio (BTW:  if you own an equity fund, chances are high that the fund owns Apple in 2012-2015; so, you do own a piece of APPL, whether you know it or  not!) .. & now think about a situation that the market has gone down 4.5% over last two days (happened several times in 2015 as well as 2016) … further, think how hard it is to make a decision either to buy more or sell at this point, especially when you made a purchase in your 401K account couple of weeks ago … You won’t make a buy decision because market is trending low and you won’t make a sell decision because that will prove you made a wrong decisions two weeks ago.

after spending a full day in tension, you decided to doing nothing … which  (a non decisiveness due to confirmation bias) will end up hurting you  regardless of market’s future direction … just stay with me for few  minutes … here is how … the market goes up next day – haha, i was right, i didn’t sell & share your success with your spouse … just  to find out that market went another 5% down in next 5 days … &  then it hurts as you gave up all the gains of the year … when you return home to your spouse and tell her that the stock market is for gamblers … she smiles inside, thinking boys will be boys, & says,  i told you to sell the other day, but you never listen to me … well,  she wins [again], you lose .. & you wonder why she is always right  … because you are the one who is under the influence of Confirmation bias, and she is not ..! … because she doesn’t own that security/fund  … you do [in your account] … & therefore, she can make an  objective decision, but you can’t … and it’s all about “being human” courtesy Salman Khan ..!

conclusion: you can’t make an objective decision about an security when you already own it (long or short).

Buffett  generally adds to his position if a stock that he own goes down since he has already calculated its price before owning and he sticks to it  … as a trader, i make those buy or sell decisions before making the  trade … so you know, as a day trader, i “sleep in cash”  each night .. for me, each day is a new day .. & nights too … what were you thinking? therefore, i can objectively choose whether to go long or short next day … and also change my mind on a moment’s notice OR actually with NO notice ..!

regret aversion bias (or loss aversion bias)

humans avoid the feeling or regret experienced after making a choice with a negative outcome … investors who are influenced by anticipated regret take less risk because it lessens the potential for poor outcomes …  that’s why we hold onto losing investments – to avoid confronting the fact that we have made a poor decision …

i am sure all of you have experience of this bias … but here is mine  … in mid 2000s, while working at PMI Group in mortgage insurance  business, i purchased the stocks of both Fredie (FRM) and Fennie (FNM)  … FRM & FNM are/were mortgage powerhouse backed by US govt. … interestingly, i purchased FRM in my personal brokerage account and FNM in my 401K account & held them post real-estate burst …  as both of these stocks started going down, i sold my FRM position, took the loss & matched with the gains in other positions … so no regrets … however, i held onto FNM in 401K account as those losses can not be matched against the gains .. and i ended up losing most of the capital invested in FNM, as i was not ready to deal with a regret that i am a bad stock picker … & i made some really good picks in those days using my model.

lesson learned: i no longer invest in individual companies and i wouldn’t recommend you unless you know them intimately well and keep up with them  on regular basis, like Buffett does ..!

disposition effect bias

a tendency to label investments as winners or losers [as as after effect] … disposition effect bias can lead an investor to hang onto an investment that no  longer has any upside or sell a winning investment too early to make up for previous losses.

there is a interesting and funny story about this one .. i moved to  individual stock [from mutual funds] when i joined Charles Schwab and opened my brokerage account in 1997 … i bought whole bunch of stocks .. & they all went up in 1998 – 2000 and of course, i made good money as i was riding on the bull, but as the tech bubble was burst, i had some individual stocks in my portfolio  .. good thing was that i held onto them with a belief that they will come back so held them during 2001-2003 … and then i started buying new securities in 2004 onward … as the new securities went up, i marked them as winners in my mind .. something i realized later that while i was selling the new securities, i held onto the oldies for a long time, due to disposition bias, as i believed that they will return to gains, although in reality the fundamentals were saying that the oldies have no upside from their current level. 

lesson learned: it’s hard not to have emotions attached to the securities you own; hence our tagline – investments minus emotions; in general, when you opening a trade, you should know a closing price & time target (both up & down scenarios) unless you are a forever kinda investor like Buffett.

hindsight bias

this bias leads an investor to believe after the fact that the past event was predictable and completely obvious. 

this is the toughest one, but before i talk about it, you may want to listen to a discussion with Eugene Fama & Richard Thaler, both Noble prize winners on Markets / Behavior Page, & come back here.

Mr. Fama’s argument is that all the information available in the market is already reflected in the price and there is no such thing as bubbles, and what happened in 2000 or 2008 were the anomalies & there is no systematic way to define them … on the contrary, based on behavioral aspects Mr. Thaler’s argument is that humans are driven by greed and fear, and hence don’t make rational decisions.

i kinda agree (partially) with both of them … not because i am playing  diplomatic, but mainly due to the fact that both are noble prize  winners, so, they must be saying something right … however, the fact remains that neither of them is providing any solution on how to deal  with these bubble / manic / irrational exuberance situations, which occurs  time to time … so i took this task as a challenge and studied all of the them (stock market bubbles) in depth since tulip mania … you don’t wanna know how many books i have purchased and read on this topic and i am still discovering new  things … also, this may end up as my doctorate thesis some day (possibly after i am dead), as getting a doctorate is not my current objective.

here is a synopsis: on Mar 15, 2000, when Nasdaq reached an all time high, how would you know that this is the day it is at its peak and the bubble is burst … or in 2008, that the market will reach its lowest point roughly six months after the Lehman moment.

well, the answer is: You don’t … and it is mainly because you are looking  for a bubble when you are already inside one … no one is going to send you a post card on those days, saying today is the last day of this  bubble; therefore, please sell all your holdings!

these bubbles, which turn into disasters – i.e. S&P going down 50% or more, take years to build … as an engineering student, if i need to diagnose this problem, i will look for bubble development or leaks when  they are small (during design & development period); i.e. if i can’t see them in hindsight, i will start looking for them in  foresight … and not when they are about to burst (product is ready to ship or to consume) & looking them into hindsight … so, i started tracing histories of bubbles really deep to study their characteristics  & discovered that the bubbles are formed inch-by-inch day after day resulting in formation over years … however, not all the bubbles become big to turn into a tech boom / bust or a real-estate bubble that turned into the great recession … most of them stay small (or think of  them as mini-balloons) and flatten overnight as the air escapes … but some continue to grow & grow, as most of us take one side & ignore the facts … e.g. “house prices will never go down in  California” … i heard this line from several really smart people  during 2004 – 2005 until when the bubbles become giant and  eventually burst.

lesson learned:  bubble form everyday & i am able to see and experience them everyday (like in The Sixth Sense – i see people !) but most of them  disappear in a day or few days, but some stay and they do become huge  … & they do serious harm when burst … it’s not easy to see them from an investor’s lens, but as a trader, i deal with them everyday …  to be continued.

familiarity bias

it occurs when an investor has preference for familiar or well-known investments despite the seemingly obvious gains from diversification … the investors may prefer stocks and bonds for companies/industries  they are familiar with – like investing in the stock of your  company / industry / country … this can lead to sub-optimal portfolios with a greater a risk of losses.

this one is easy to describe, as all those folks who worked at Charles  Schwab & Cisco & other high growth companies during 1990s and held onto the stocks of these companies through the tech bubble .. i know i held SCH through this cycle, as i worked with Charles Schwab in late 1990s.

self-attribution bias

Investors tend to attribute successful outcomes to their own actions and bad  outcomes to external factors, as a means of self-enhancement, leading the investor become overconfident.

this one is funny and again sharing my own experience … by 2000, i thought i am a successful investor, as i avoided internet stocks … but when it rains, it pours … even S&P went down 50% … so, 5 years later, i discovered that i was riding the bull [market in late 1990s] ..!

trend-chasing bias

Investors often chase past performance in the mistaken belief that historical returns predict future investment performance.

this one is easy too … as you look at an advertisement by a mutual fund/ETF brokerage company stating last year, 3 years, 5 years returns for those mutual funds/ETFs, would you select the one which has the highest or lowest returns last year … you don’t have to answer .. it’s human nature, and yes, you are wrong ..!

in my discussions with other traders, i tell them that i have only one girl friend (can you guess who ? … you should know if you follow my blog, as i write about her every day – ms. market!) … & therefore, i don’t have to make a selection each time [i do buy or sell] … she stays with me during the ups & down [of the market] .. don’t get senti ..!  and, it’s hard to keep up with one … and that’s why Warren purchases selective companies / stocks … so, for those who manage a number of positions or girlfriends … good luck ..!

recency bias

Recency bias is the  phenomenon of a person most easily remembering something that has  happened recently, compared to remembering something that may have  occurred a while back. 

Buffett describes it better, “People tend underestimate low probability events when they haven’t happened recently and over estimate them when they have happened recently. ” 

blind spot bias

the bias blind spot is the cognitive bias of recognizing the impact of biases on the judgment of others, while failing to see the impact of biases on one’s own judgment. 

this is the hardest for me .. as i look for biases in the statements/thinking of others, but being a strong headed person, i generally don’t listen to folks, unless i am convinced that you are an expert, which, if you read carefully, is a catch 22 problem.  

Conclusion

In my opinion, there are only two ways to deal with these biases: 

         1) become a really long-term investor like Buffett, or 

          2) a really short-term trader like me

but just to add some spice to this statement … neither of these is easy ..!

hope you enjoyed reading my failures based on various biases and how i am trying to deal with them …  further, i would like to remind you that just because there is no easy solution to deal with [natural] human behavior, it doesn’t mean you should jump to become a trader. 

OTOH, if you end up becoming one, do remember the words of the legendary trader, Jesse Livermore, “The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the man of inferior emotional balance, or for the get-rich-quick adventurer. They will die poor.” 

another excellent book is Charlie [Munger]’s Almanac which talks about various biases.

feel free to share these with your spouse telling her how much a smart dude you are since you didn’t make any of these mistakes in your investment journey … certainly a good topic of discussion.