Its all about pschology

I think behavorial finance is a very important topic for an investor (and in other walks of life too) and one should spend some time learning about and trying to avoid the common psychological pitfalls. I discussed some of these pitfalls in the previous posts (hereand here).

Poor charlie’s almanac
Thinking fast and slow
The psychology of influence
The art of thinking clearly
Seeing what others don’t : The remarkable ways we gain insight

Lets explore a few more baises and how one can avoid them

Sunk cost fallacy
This is a tendency of investors to throw good money after bad. Once you make an investment in a stock and the price starts to drop, the general tendency is to average down. If one analyses the company based on current facts and arrive at an objective conclusion that the price drop is unwarranted,  then buying/ averaging down is a good approach. However most investors (including me) remain anchored to the previous conclusions and are also influenced by the sunk cost – money already invested in the stock. As a result, majority of the investors refuse to change their mind and incur heavier losses in the future.

I have been guilty of this fallacy a lot of times and find it difficult to change my mind quickly. At present, the best antidote I have is to acknowledge my weakness, look for disconfirming evidence and act on it, inspite of looking like a fool at that time.

Story bias
Humans are suckers for stories. We understand the world in the form of stories. Our epics and mythology are stories and so are films and other forms of entertainment.

How does one avoid getting sucked in? There is one word for it – valuations. Never overpay for stocks, no matter what the story. If something is obvious to everyone, then the price reflects it and it is ‘overconfidence and hubris’ on part of most investors to assume that they are smarter than the market.

Almost everyone tends to neglect the base rate – statistical probability of an event. Investors tend to do the same. Let’s consider some examples – 90% + options expire worthless and various studies have shown that IPOs tend to underperform market over the long run. Inspite of these statistics, investors believe they can do better, mostly because they are not even aware of the low success rates.

In summary, know where you have an advantage and work on exploiting it. For example – I know for a fact that I cannot beat a full time trader in the short term and hence I will never invest in a stock or option where the odds are stacked against me.

One needs a level of optimism or confidence to do well in life. At the same time, there is fine line between confidence and over confidence. How do you know you have crossed it?

What about me? I have had the reverse problem – I have always been underconfident and that has been harmful too. I have underallocated to equities in the past and created smaller positions in my top ideas. As a result, my opportunity loss has been far higher than my actual losses.

No silver bullets
We have reviewed several biases in a series of posts. As you can see, it is easy to understand these biases and even recognize them in yourself. It is however far more difficult to overcome them – I am often aware that I am irrationally committed to an old idea, but still struggle to exit/ sell the stock.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.