How Behavioural Biasness Affects Investment Performance [Part 1]

We often believe that we know what is best for us and that we have the full control over our thoughts, our actions and our lives. That may still be true to a large extent but many decisions we make daily, big or small, are heavily influenced by subconscious factors.

You might have unknowingly committed several behavioural biasness that have resulted in your poor investing performance. Yet, you probably attributed your failures to bad luck.

The most successful value investors are unlike those Wall Street superstars depicted in the movies. They are humble, intelligent and most avoid the spotlight. They have an aura of control and serenity emanating from their presence regardless of the situation.

These individuals have achieved this through decades of experiences and committing countless mistakes.

In this article, we aim to highlight several potential behavioural biasness to avoid and how you can achieve greater control over your investment decisions.

Charlie Munger: 24 Standard Causes of Human Misjudgment

While there are numerous psychology books and articles that talk at great length about human psychology, Charlie Munger managed to integrate psychology with the financial market better than most.

Charlie Munger, Vice Chairman of Berkshire Hathaway, is also the partner of Warren Buffett. Working hand in hand with the legendary value investor, he has provided Buffett with great personal insights that have value-added his investments.

Amongst the numerous excellent articles and interviews he gave, one piece stood out the most. He gave a lecture to a group of Harvard Law school students on the 24 common behavioural biasness that affects our investment performance.

Here, we shall touch on several key aspects that we believe are crucial in your lives, not just in your investing journey.

Power of incentives

Yes, of course incentives motivate people; however, why are we stating the obvious?

The truth is, we frequently underestimate the power of incentives. This incentive motivates you to work towards your goal and gets you through the rut.

What’s the reason you wake up every morning? To strive for your goals or are you just living aimlessly?

Since you are reading our article, chances are, you already have the desire to learn.

Hence, know your motivations.

In the investment setting, incentives influence the daily decisions of top management. Knowing what motivates the executives to work every day will spare you the frequent heartbreak of realising your portfolio losses.

As we have mentioned in another article on Tweedy, Browne’s 10 ways to beat the market index, several characteristics such as frequent stock buybacks and high insider buying are positively correlated with stock returns. One of the fundamental reasons that may explain this trend is because it shows that the management’s incentives are aligned with the shareholders’ – sustainable growth in the long run.

Denial

Denial is a behavioural defense mechanism in which confrontation with a personal problem or with reality is avoided by denying the existence of the problem or reality.

As a third party, it may seem to be outright obvious when someone else is in denial. However, when you are the victim instead, things may not be as easy as it seems.

Sometimes, reality may be too painful to bear so you may distort it so that it’s bearable. This defense mechanism allows us to feel better about everything by hiding behind a veil of make-believe stories.

We all do that to some extent and being aware of this weakness allows us to make better investment decisions.

One fine example of how denial can destroy bright investors’ wealth would be the denial of an investment mistake.

Look at the above, where Bill Ackman was long Valeant shares and defended his position all to the end. This is one great example, where he was unwilling to accept the problems faced with his investment and continued averaging down on the company, resulting in his firm raking up approximately US$4 billion in losses.

Ackman hadn’t previously apologised — at least, in such direct terms — for the big loss. The hit came from holding what was eventually nearly a 10% stake in the drugmaker, which was fighting charges of accounting fraud and price gouging, among other issues. The hedge fund manager first accelerated Pershing’s investment when Valeant’s stock was priced near $196 a share in early 2015; by the time he sold it this month, it was worth $11 a share.

Market Watch (https://www.marketwatch.com/story/bill-ackman-apologizes-for-4-billion-valeant-mistake-finally-2017-03-30)

Smart investors are often unfortunately prone to having an inflated ego. After having a good track record, one may suddenly feel unbeatable. This investor may gradually cultivate the mindset of attributing all mistakes to bad luck instead of taking responsibility. Without taking any form of responsibility, this poor soul will never learn his mistake and inevitably meet his downfall.

Open your eyes, the sooner the better!

Consistency and commitment

When you have finally decided to buy a new pair of earpiece after researching for hours for the right model, off you go to the electronic store to get it.

Sadly, the sales assistant told you that the model you wanted is out of stock until next year. Will you just turn around and head home?

Whether you want an earpiece or not, chances are, you will be finding for an alternative pair.

This is a behavioural phenomenon called consistency and commitment. Once you commit your mind towards attaining something, you will experience a sense of duty to achieve it.

Stage 1: I will find the earpiece.

Step 2: Failed to find the earpiece. Now, I have to find an alternative.

Stage 3: An alternative earpiece found. Despite, the alternative earpiece lacking in some areas, I settle for less. Task completed. Satisfaction achieved.

Will you be finding the next investment opportunity like how you shop for your next earpiece? Let’s hope not!

Importance of psychology

While humans are the smartest species on the entire planet, we aren’t perfectly rational all the time. Through generations, we have developed mental short-cuts to make decision-making more efficient. While it provides more benefits all in all, these mental short-cuts may lead you to make grave mistakes unknowingly.

The study of human behavior is psychology. By incorporating our understanding of psychology into value investing, we are able to bring life into theories and quantitative approaches to reflect the real world.

For readers interested in following me in terms of my speaking schedule, do check out our events page here. I will try to update it as regularly as possible, so do check back from time to time to see when I will be speaking next or what are some of my upcoming workshops that I do in collaboration with SGX Academy. Additionally, you may follow me on Instagram @investingnook to get more updates on my speaking schedule!