Tuesday, May 17, 2011

Bye Bye Bias–Key to successful investing

Fundamental analysis and technical levels are all fine. But those who have been in the markets for any length of time understand one important dimension of successful investing, and that is – Behavioural aspects of investing. Overcoming investing bias is key to superior results in the investment process.

Making mistakes is acceptable because they are the best teachers. But the problem is unless one understands behavioural side of investing, it is difficult to figure out the primary mistake itself. With this background, I intend to discuss some of the investing biases in this post which often lead to mistakes on the part of the investor.

Human mind is wired to fixed tendencies, and takes decisions according to emotions and those mind patterns. Self-control over impulses is generally difficult to exercise for ordinary investors. Hard wired to herd and inability to look beyond the obvious (however silly that may be) can often be undoing a good investment decision.

Bias # 1 : Thirst for Agreement

We also know this as confirmatory bias. In simple words, we form a view and then spend rest of the day or week looking for information that agrees with that view, howsoever wrong that view or hypothesis may be. As humans, it feels good to hear the same opinion as ours. In investing, it can be a huge disadvantage if we can't accept refutation. Another manifestation of this "thirst for agreement" bias is that any media source, TV channel or information that disagrees with our view, we label that as biased.

Bias # 2 : Price Anchoring

Let me explain anchoring bias with an example psychologists and experts give on this factorial calculation. What is the value of 8! This is asked to participants in 2 different surveys, one as 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 and another as 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8.

Surprisingly, median result of both surveys was not found the same. Under first scenario, median answer was 2250. In second scenario where smaller numbers are appearing first, median answer was 512. What's your guess? Want to know the correct answer, without troubling your excels and calc. Well, it's 40,320.

Coming to stocks, we see the price tape and screens for so long that we are "anchored" to a particular price point, and anything optically different is not readily accepted even if that valuation may be more realistic. People have become so used to Reliance quoting in range of Rs 950 to 1050, that if I say I want to buy it at Rs 750, most would grin or frown at me depending on which side of the position you're.

Bias # 3 : Heads my skill, Tails bad luck

Remember the period - October 2008 to March 2009 in markets when anything we touched turned gold, well almost. But smart folks say it was entirely their skill to have got those stocks right (Heads). I can give them credit for courage and timing because those were gloomy days, but for skill…no. It was nothing great to create multi-baggers in one year for anyone who invested then. On the other hand, poor stock selection (Tails) whatever may be the month or year, is called by us as bad luck. At this time, we don't bring our bad skill set on to the fore. After all, it hurts self-esteem to admit so. This self attribution bias, is a big hurdle to recognizing mistakes and learning from them.

We have discussed only 3 biases in this post, they are many more…will continue some other time.

Good thing is these mind patterns can be attuned or set right with a little bit of mind re-training and self-regulation. It's not without reason old timers stress upon discipline and patience for success in all walks of life, investing included. Give it a try and share your experiences.

I conclude with gem of a quote attributed to WB:

"You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right- and that’s the only thing that makes you right."

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