The Biggest Enemy in Investing is Yourself

 

Behavioural Finance - The Biggest Enemy in Investing is Yourself

Your opening statement is the core truth of behavioural finance. While we often look for external villains—volatile markets, economic downturns, bad advice—the most significant source of investment error is our own ingrained psychological biases.

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1. The Core Conflict: Man vs. "Rational Economic Man"

• Traditional Finance (The "Rational" Model): This is the old paradigm. It assumes that investors are "rational actors" who:

  • Process all available information logically and without emotion.

  • Make decisions solely to maximize their wealth (utility).

  • Are consistent in their risk tolerance.

  • This model is elegant and forms the basis of theories like the Efficient Market Hypothesis (EMH), but it's a poor description of how people actually behave.

• Behavioural Finance (The "Realistic" Model): Pioneered by psychologists Daniel Kahneman and Amos Tversky (Nobel Prize, 2002), this field acknowledges that investors are "normal," not always rational. They are:

  • Influenced by emotions (fear, greed, regret).

  • Use mental shortcuts (heuristics) that often lead to errors.

  • Systematically prone to cognitive biases that distort judgment.

The central insight is that these irrational behaviors are not random; they are predictable and systematic. By understanding them, we can defend against them.

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2. Deep Dive: Recency Bias (The Party Effect)

Your notes provide a perfect case study. Let's break down the "Party Effect" and its implications.

What it is: Recency Bias is the tendency to weigh recent events more heavily than earlier ones when making decisions. Our brains are wired to believe that what happened yesterday will continue to happen tomorrow.

The Party Analysis - Why It's So Powerful:

The example of the four guests is brilliant because it shows that the exact same investment (the S&P 500 fund) can produce entirely different realities and emotions for different people, based solely on their entry point.

• Guest 1 (30 months, +12.28%): Has lived through a full cycle. While uncomfortable with the recent downturn, their overall experience is positive. They are likely to stay invested.

• Guest 10 (21 months, +1.36%): Feels frustrated. They missed the big early gains and have seen their profits evaporate. They are on the fence, susceptible to selling on a further dip.

• Guest 19 (12 months, -21.53%): Is in a state of panic and regret. Their entire experience is negative. They believe "the market is a terrible place" and are highly likely to sell to stop the pain, potentially locking in losses at the bottom.

• Guest 25 (6 months, -11.42%): Also panicked, but may hold on slightly longer, hoping to "break even." Their entire perspective is framed by the recent bear market.

The Dangerous Consequences:

1. Buying High, Selling Low: This is the ultimate investor sin, and Recency Bias is its primary driver.

   • During a bull market (everyone is making money), the recent past is positive. Greed and FOMO (Fear Of Missing Out) take over, leading people to buy after prices have already risen significantly.

   • During a bear market (prices are falling), the recent past is negative. Fear and panic set in, leading people to sell after prices have already fallen, crystallizing their losses.

2. The "This Time is Different" Mentality: Recency Bias fuels the belief that current market conditions (a boom or a bust) are a "new normal" and that historical patterns no longer apply. This leads to a abandonment of long-term strategy.

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3. Other Critical Biases and Heuristics

Beyond Recency Bias, here are other common enemies in the investing psyche:

• Overconfidence: We tend to overestimate our own knowledge, skill, and ability to predict the future. This leads to excessive trading, under-diversification, and ignoring contrary evidence. (Mentioned in the Yale lecture).

• Confirmation Bias: We actively seek out information that confirms our existing beliefs and ignore or dismiss information that contradicts them. An investor who buys a stock will then only read positive news about it.

• Loss Aversion (from Prospect Theory): This is a foundational concept. The pain of losing $100 is psychologically about twice as powerful as the pleasure of gaining $100. This makes us irrationally hold onto losing investments (hoping to avoid realizing the loss) and sell winning investments too early (to "lock in" a gain).

• Anchoring: We rely too heavily on the first piece of information we receive (the "anchor"). For example, an investor might fixate on the high price a stock once reached ($150) and refuse to sell it at $80, even if the fundamentals have deteriorated, because $80 seems "low" compared to the anchor.

• Herd Mentality: The tendency to follow the actions of a large group, even if it's irrational. This drives asset bubbles and crashes.

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4. How to Fight Your Inner Enemy: A Practical Guide

The notes correctly state that this is the "deadliest of all traps." Overcoming it requires a systematic defense.

1. Educate Yourself: This is the most powerful weapon. You don't need to become a professional trader, but you must understand the fundamental principles of investing (what is a stock? a bond? what is diversification? what is a market cycle?) and, crucially, the principles of behavioural finance itself. Knowing these biases by name allows you to spot them in your own thinking.

2. Create a Rules-Based Plan (An Investment Policy Statement): You must make your crucial decisions when you are thinking clearly, not in the heat of the moment. Your plan should define:

   • Your long-term goals (retirement, a house, etc.).

   • Your asset allocation (what percentage in stocks, bonds, etc.).

   • Clear rules for rebalancing (e.g., "I will rebalance my portfolio back to my target allocation every 12 months").

   • This plan acts as a "circuit breaker" for your emotions.

3. Embrace Dollar-Cost Averaging: This technique, where you invest a fixed amount of money at regular intervals (e.g., monthly), automatically fights Recency Bias. You buy more shares when prices are low and fewer when prices are high, smoothing out your entry point and preventing you from trying to "time the market."

4. Hire the Right Kind of Advisor: The notes are emphatic and correct here.

   • Fiduciary Duty is Non-Negotiable: A fiduciary is legally and ethically obligated to put your interests first. This removes the "conflict of interest" variable. Many advisors at large wirehouses (like those mentioned: Merrill Lynch, etc.) are not held to a fiduciary standard and may be incentivized to sell you products that are good for them.

   • Your Advisor as a "Behavioral Coach": A good fiduciary advisor's greatest value may not be stock-picking, but being the voice of reason when you are panicking or becoming greedy. They help you stick to your plan.

Conclusion

Behavioural Finance doesn't just make us smarter investors; it makes us more self-aware individuals. It teaches us humility, patience, and the value of discipline. The market's volatility is a given. Your reaction to it is the variable you can control. By understanding that your biggest enemy is the collection of biases and emotional reflexes within you, you can build the defenses necessary to achieve long-term success.

In short: Master the market by first mastering yourself.

The Story:  Welcome to the party

When describing the stock market each participant sees their portfolio’s performance from their perspective only and thus they are always “right” which leads to what I call The Party Effect or what Financial Behaviorist call the Recency Bias.

Imagine that you attended a party hosted by your investment advisor and that in addition to you, also in attendance were several other clients. As you go around the room and meet people you learn that everyone at the party owns the exact same S&P 500 index mutual fund. I use the S&P 500 for this tale because by many measures it has historically produce an average rate of return of about 12% and as many people know, and now you know as well, it represents what many investors call “the stock market.” The question then is would everyone have the same rate of return at this party? Of course the answer is, no they would not. If they started at the same time they would but since people invest or come into the life of the investment advisor at different times, the answer is no.

Let’s tighten up the party attendee list and invite only 30 guests. For simplicity, let’s assume that Guest 1 purchased the fund 30 months ago, that Guest 2 purchased it 29 months ago, that Guest 3 purchased it 28 months ago, etc. What would the guests discuss? What would be their perspectives of the stock market?

In order to determine what the guests would discuss and how they would evaluate their performance we need to have some data in the form of monthly rates of return. So we need to develop a monthly rate of return for 30 months to see what they see. Again, for simplicity, assume that for the first 18 months the fund goes up 3% per month and for the next 12 months it goes down 2% per month. Please note that I didn’t pick this sequence of numbers randomly. I have a purpose to this. This particular sequence approximates how the stock market moves in terms of bull and bear market duration and after 30 months returns approximately 12%; 12.28% to be exact. This sequence of numbers is a good sequence to illustrate The Party Effect or Recency Bias. We can characterize the first 18 months as the bull market phase of the 30-month cycle and the last 12 months as the bear market phase of the 30-month cycle.

To illustrate The Party Effect lets focus on 4 guests and see how they describe the stock market. Let’s look at guests 1, 10, 19 and 25. I picked these 4 because readers of this tale can relate in some form or another to one of these 4.

- Guest 1 started 30 months ago, at the beginning of the bull market phase, and his rate of return is 12.28% for the entire 30-month cycle. He enjoyed the ride up for 18 months and now the ride down for the last 12.

-  Guest 10 started 21 months ago, halfway through the bull market phase, and his rate of return is 1.36%    for the 21-month period he has been invested.

-  Guest 19 started 12 months ago, at the beginning of the bear market phase, and his rate of return is  -21.53% for the 12-month period he has been invested.

-  Finally, Guest 25 started 6 months ago, halfway through the bear market phase, and his rate of return is  –11.42 for the 6-month period he has been invested.

These 4 guests experienced entirely different rate of return outcomes and view their portfolios and thus the stock market completely different. All 4 are correct. All 4 are right and yet they couldn’t possibly have more divergent outcomes. If they don’t have a complete picture of the stock market, they can get themselves in trouble. The difference between the best performing portfolio that is up 12.28% and the worst performing portfolio that is down 21.53% is an astounding 33.81%. Is this too obvious? You may say, of course they have different outcomes, they started at different times but that is not the point. The point is that stock market investing will always produce different outcomes. One guest started at the worst time possible. Another guest started at the best possible time. How they look at the past determines how they see the present. Most importantly, it will determine how they will act going forward.

The Party Effect simply states that stock market participants evaluate their portfolio performance based on their perspective and their perspective only. They do not see the market as it is but as they are. Without an expert understanding of how the stock market works, this leads to incorrect conclusions that ultimately lead to incorrect decisions. The field of Behavioral Finance (BF) has shown time and time again that people have variable risk profiles. BF demonstrates that fear is a stronger emotion than greed. This means that in our simple 4 guest example, Guests 3 and 4 are more likely to exit the stock market at just the wrong time since their recent, thus Recency Bias, experience is one of losing money. It means that Guest 1 and 2 are more likely to stay invested, thus catching the next wave up that is likely to follow. All 4 have intellectual access to the events of the last 30 months. All 4 can educate themselves on the stock market. However, their particular situation is so biased by recent events that the facts are unimportant. They behave irrationally. I have witnessed this irrational behavior throughout my career. No one is immune, even advisors.

Behavioural Finance. The biggest enemy in investing is yourself.

 Behavioural Finance. The biggest enemy in investing is yourself.

Elaboration of Section 29

This section introduces one of the most critical yet overlooked aspects of investing: Behavioral Finance. This field studies how psychological influences and biases cause investors to act irrationally, often to their own severe financial detriment. The central thesis is that your own psychology is a greater threat to your success than any market crash.

1. The Core Concept: The "Party Effect" or Recency Bias
The section uses a powerful allegory, the "Party Effect," to explain a common behavioral bias known as Recency Bias. This is the tendency to weigh recent events more heavily than earlier ones and to extrapolate recent trends into the future indefinitely.

• The Party Scenario: Imagine 30 guests at a party. Each bought the same S&P 500 index fund, but they started investing in consecutive months over a 30-month period.

• The Market Cycle: The first 18 months were a bull market (prices rising 3% per month), followed by 12 months of a bear market (prices falling 2% per month). Over the full 30 months, the fund returned a healthy 12%.

• The Divergent Perspectives:

  • Guest 1 (started 30 months ago): Sees a +12% return. He is content.

  • Guest 10 (started 21 months ago): Sees a +1.36% return. He is disappointed.

  • Guest 19 (started 12 months ago): Sees a -21.53% return. He is panicked and believes the stock market is a terrible place.

  • Guest 25 (started 6 months ago): Sees a -11.42% return. He is fearful.

• The Lesson: All four guests are looking at the exact same investment, but their personal experience (their "recent" history) gives them a completely different, and often incorrect, perception of the market. This bias leads them to make poor decisions—the losing investors are likely to sell in a panic at the worst possible time, while the winners may become overconfident.

2. The Consequences: How Biases Destroy Wealth
Behavioral finance shows that these ingrained biases lead to predictable and costly errors:

• Selling Low and Buying High: Driven by fear (during downturns) and greed (during bubbles).

• Chasing Performance: Buying into hot sectors or funds after they have already seen massive gains, only to be caught in the subsequent crash.

• Overconfidence: Believing you know more than the market, leading to excessive trading and risk-taking.

3. The Solution: Expertise and Self-Awareness
The section concludes that the only way to overcome these powerful psychological traps is through one of two paths:

• Become an Expert Yourself: By deeply understanding how the market works and being aware of your own biases, you can learn to manage your emotions and stick to a disciplined strategy. You recognize market downturns as opportunities, not threats.

• Hire a True Expert (and Be Able to Identify One): If you cannot become an expert, you must find a trustworthy, knowledgeable advisor who can act as a rational guide. However, the section warns that this is difficult if you lack the expertise to judge their competence and integrity in the first place.

4. The Yale University Lecture
The link to the Yale lecture provides an academic foundation for these ideas, covering concepts like:

• Prospect Theory: How people value gains and losses differently, leading to irrational decision-making.

• Overconfidence: The tendency to overestimate one's own knowledge and ability.

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Summary of Section 29

Section 29 argues that the most dangerous enemy an investor faces is their own psychology, which leads to systematic errors like Recency Bias—the tendency to make decisions based on recent experiences rather than long-term facts.

• The Core Problem: Investors' perceptions are distorted by their personal entry point into the market (the "Party Effect"). This leads to emotionally-driven decisions, such as selling in a panic after recent losses or buying into manias after recent gains.

• The Field of Study: Behavioral Finance explains these irrational but predictable patterns.

• The Ultimate Challenge: You cannot avoid these psychological traps by abdicating responsibility. You must either:

  1. Become an expert to manage your own behavior, or

  2. Develop the expertise to identify and hire a truly competent, ethical advisor to do it for you.

In essence, this section teaches that winning the inner game is a prerequisite for winning the financial game. No amount of financial analysis will help an investor who cannot control their own fear and greed. The intelligent investor must not only analyze companies but also conduct a ruthless self-analysis to overcome the biases that doom the majority to failure.

Behavioural Finance: We are hardwired to be lousy investors.

1.  We are hardwired from birth to be lousy investors.

Our survival instincts make us fear loss much more than we enjoy gain.  We run from danger first and ask questions later.  We panic out of our investments when things look bleakest - we are just trying to survive!  We have a herd mentality that makes us feel more comfortable staying with the pack.  So buying high when everyone else is buying and selling low when everyone else is selling comes quite naturally - it just makes us feel better!

We use our primitive instincts to make quick decisions based on limited data and we weight most heavily what has just happened.  We run from managers who performed poorly most recently and into the arms of last year's winners - that just seems like the right thing to do!  We all think we are above average!  We consistently overestimate our ability to pick good stocks or to find above-average managers.  It is also this outsized ego that likely gives us the confidence to keep trading too much.  We keep making the same investing mistakes over and over - we just figure this time we will get it right!

We are busy surviving, herding, fixating on what just happened and being overconfident!  Maybe it helps explain why Mr. Market acts crazy at times.

2.  So, how do we deal with all these primitive emotions and lousy investing instincts?  

The answer is really quite simple:  we don't!

Let's admit that we will probably keep making the same investing mistakes no matter how many books on behavioural investing we read.

3.  How to invest in the stock market?

Traditionally, stocks have provided high returns and have been a mainstay of most investors’ portfolios. Since a share of stock merely represents an ownership interest in an actual business, owning a portfolio of stocks just means we’re entitled to a share in the future income of all those businesses. If we can buy good businesses that grow over time and we can buy them at bargain prices, this should continue to be a good way to invest a portion of our savings over the long term. Following a similar strategy with international stocks (companies based outside of the United States) for some of our savings would also seem to make sense (in this way, we could own businesses whose profits might not be as dependent on the U.S. economy or the U.S. currency)

4.  These words of wisdom from Benjamin Graham

In an interview shortly before he passed away, Graham provided us with these words of wisdom:

The main point is to have the right general principles and the character to stick to them.… The thing that I have been emphasizing in my own work for the last few years has been the group approach.  To try to buy groups of stocks that meet some simple criterion for being undervalued—regardless of the industry and with very little attention to the individual company.… Imagine—there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up.

That interview took place thirty-five years ago. Yet we still have an opportunity to benefit from Graham’s sage advice today.

I wish you all—the patience to succeed and the time to enjoy it. Good luck.

Book:  Joel Greenblatt:  The Big Secret for the Small Investor (2001)

Regret Theory

Fear of regret, or simply regret theory deals with the emotional reaction people experience after realizing they've made an error in judgment.

Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock.

• So, they avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss.  We all hate to be wrong, don't we?

What investors should really ask themselves when contemplating selling a stock is:
"What are the consequences of repeating the same purchase if this security were already liquidated and would I invest in it again?"

• If the answer is "no," it's time to sell; otherwise, the result is regret of buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made – and a vicious cycle ensues where avoiding regret leads to more regret.

• Regret theory can also hold true for investors when they discover that a stock they had only considered buying has increased in value.

Some investors avoid the possibility of feeling this regret by following the conventional wisdom and buying only stocks that everyone else is buying, rationalizing their decision with "everyone else is doing it."

• Oddly enough, many people feel much less embarrassed about losing money on a popular stock that half the world owns than about losing money on an unknown or unpopular stock.

Psychology and Investing: Herding

Stock Ideas

There are thousands and thousands of stocks out there.  Investors cannot know them all.

In fact, it is a major endeavor to really know even a few of them.

But people are bombarded with stock ideas from brokers, television, magazines, Web sites, and other places.





Herding Behaviour

Inevitably, some decide that the latest idea they have heard is better idea than a stock they own (preferably one that is up, at lead), and they make a trade.

In many cases the stock has come to the public's attention

• because of its strong previous performance, 
• not because of an improvement in the underlying business.

Following a stock tip, under the assumption that others have more information, is a form of herding behaviour.





Temporary Comfort from investing with the Crowd or a Market Guru

This is not to say that investors should necessarily hold whatever investments they currently own.

Some stocks should be sold, whether because

• the underlying businesses have declined or 
• their stock prices simply exceed their intrinsic value.

But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons.  

We can all be much better investors when we learn to select stocks carefully and for the right reasons, and then actively block out the noise.

Any temporary comfort derived from investing with the crowd or following a market guru can lead to fading performance or inappropriate investments for your particular goals.

Psychology and Investing: Mental Accounting and Framing Effect

Most of us separate our money into buckets - this money is for the kids' college education, this money is for our retirement, this money is for the house.   Heaven forbid that we spend the house money on a vacation.

Investors derive some benefits from this behaviour.

• Earmarking money for retirement may prevent us from spending it frivolously.

Mental accounting becomes a problem, though, when we categorize our funds without looking at the big picture.

• While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously.  
• Since tax refunds are in fact our earned income, they should not be considered this way.
• For gamblers, this effect can be referred to as "house money."

We are much more likely to take risks with house money than with our own.

• There is a perception that the money isn't really ours and wasn't earned, so it is okay to take more risks with it.  
• This is risk we would be unlikely to take if we would spent time working for that money ourselves.

In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance or realized capital gains.




Framing Effect

This is one other form of mental accounting.

The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect decision.





Overcoming Mental Accounting.

The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments.

Take care not to think of your "budget buckets" so discretely that you fail to see how some seemingly small decisions can make a big impact.

Psychology and Investing: Confirmation Bias and Hindsight Bias

Confirmation Bias

How do we look at information?

Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favourably.

If we have purchased a certain stock in a certain sector, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.


Hindsight Bias

This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome.

Our judgment of a previous decision becomes biased to accommodate the new information. 

For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. 

This type of "knowledge updating" can keep us from viewing past decisions as objectively as we should.

Psychology and Investing: Anchoring

When estimating the unknown, we cleave to what we know.

Investors often fall prey to anchoring.

They get anchored on their own estimates of a company's earnings, or on last year's earnings.

For investors, anchoring behaviour manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.

When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it.

We may cling to sub-par companies for years, rather than dumping them and getting on with our investment life.

It is costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.



Overcoming Anchoring

It may be helpful to ask yourself the following questions about your stocks:

Would I buy this investment again?

And if not, why do I continue to own it?

Truthfully answering these questions can help you severe the anchors that may be a drag on your rational decision making.

Psychology and Investing: Sunk Costs

Sunk cost fallacy is another factor driving loss aversion.

This theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.

Our inability to ignore the sunk costs of poor investments causes us to fail to evaluate the situation on its own merits.

Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses.    

[?Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.]

Psychology and Investing: Loss Aversion

Loss Aversion

Many investors will focus obsessively on one investment that is losing money, even if the rest of their portfolio is in the black.  This behaviour is called loss aversion.

Investors have been shown to be more likely to sell winning stocks in an effort to "take some profits," while at the same time not wanting to accept defeat in the case of the losers.

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other since reason." (Philip Fisher, Common Stocks and Uncommon Profits).

Regret also comes into play with loss aversion.

This may lead us to be unable to distinguish between a bad decision and a bad outcome.

"We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons.  In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more."

We tend to feel the pain of a loss more strongly than we do the pleasure of a gain. 

It is this unwillingness to accept the pain EARLY that might cause us to "ride losers too long" in the vain hope that they'll turn around and won't make us face the consequences of our decisions.

Psychology and Investing: Self-handicapping

Self-handicapping bias occurs when we try t o explain any possible future poor performance with a reason that may or may not be true.

This behaviour could be considered the opposite of overconfidence.

As investors, we may also succumb to self handicapping, perhaps by admitting that we didn't spend as much time researching a stock as we normally had done in the past, just in case the investment doesn't turn out quite as well as expected.

Both overconfidence and self-handicapping behaviours are common among investors, but they aren't the only negative tendencies that can impact our overall investing success.

Psychology and Investing: Selective Memory, Cognitive dissonance and Representativeness

Selective Memory

Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing.

In terms of investments we certainly don't want to remember those stock calls that we missed (had I only bought eBay in 1998), much less those that proved to be mistakes which ended in losses.

Such memories threaten our self-image.



Cognitive dissonance

How can we be such good investors if we made those mistakes in the past?

Instead of remembering the past accurately, in fact, we will remember it selectively so that it suits our needs and preserves our self-image.

Incorporating information in this way is a form of correcting for cognitive dissonance, as well-known theory in psychology.

Cognitive dissonance posits that we are uncomfortable holding two seemingly disparate ideas, opinions, beliefs, attitudes, or in this case, behaviours, at once, and our psyche will somehow need to correct for this.

"Perhaps it really wasn't such a bad decision selling that stock?"

"Perhaps, we didn't lose as much money as we thought?"

Over time, our memory of the event will likely not be accurate but will be well integrated into a whole picture of how we need to see ourselves.



Representativeness

Another type of selective memory is representativeness, which is a mental shortcut that causes us to give too much weight to recent evidence - such as short-term performance numbers - and too little weight to the evidence from the more distant past.  As a result, we will give too little weight to the real odds of an event happening.

Psychology and Investing: Overconfidence

Overconfidence refers to our boundless ability as human beings to think that we are smarter or more capable than we really are.

Such optimism isn't always bad.  Certainly we would have a difficult time dealing with life's many setbacks if we were die-hard pessimists.

However, overconfidence hurts us as investors when we believe that we are better able to spot the next Microsoft than another investor is.  Odds are, we are not.

Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade.  Trading rapidly costs plenty and rarely rewards the effort.  Trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns.  These frictional costs will always drag returns down.

One of the things that drive rapid trading, in addition to overconfidence in our abilities, is the illusion of control.  Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.

Successful investing requires the rare ability to identify and overcome one's own psychological weaknesses.

Successful investing is hard, but it doesn't require genius.

Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Successful investing requires the rare ability to identify and overcome one's own psychological weaknesses.

Behavioural finance attempts to explain why people make financial decisions that are contrary to their own interests.

Behavioural finance has a lot to offer in terms of understanding psychology and the behaviour of investors, particularly the mistakes that they make.  

Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behaviour might move the market.

We can also focus on how the insights from the field of behavioural finance can benefit individual investors.  Primarily, we are interested in how we can learn to spot and correct investing mistakes in order to yield greater profits.


Some insights one can focus on in behaviour finance are:

• Overconfidence
• Selective Memory
• Self-Handicapping
• Loss Aversion
• Sunk Costs
• Anchoring
• Confirmation Bias
• Mental Accounting
• Framing Effect
• Herding

Psychological Biases

Loss Aversion

Behavioural finance asserts that investors exhibit loss aversion, that is, they dislike losses more than they like comparable gains.

This results in a strong preference for avoiding losses as opposed to achieving gains.

Advocates of this bias argue that loss aversion is more important to investors than risk aversion,, which is why the "overreaction" anomaly is observed.

While loss aversion can explain the overreaction anomaly, studies have shown that under reactions are just as common as overreactions, which counters the assertions of this bias.



Herding

Herding behaviour is a behavioural bias that explains both under reactions and overreactions in financial markets.

Herding occurs when investors ignore their own analysis, and instead make investment decisions in line with the direction of the market.



Overconfidence

Overconfdence bias asserts investors have an inflated view of their ability to process new information appropriately.

Overconfident investors are inaccurate when it comes to valuing securities given new information, and therefore stocks will be mispriced if there is an adequate number of such investors in the market.

Evidence has suggested that overconfidence has led to mispricing in most major markets around the world, but the bias has been observed predominantly in higher-growth companies, whose prices are slow to factor in any new information.

Another aspect of this bias is that overconfident investors tend to maintain portfolios that are less-than-optimally diversified because they tend to overestimate their stock-picking abilities.




Information Cascades

An information cascade refers to the transfer of information from market participants who are the first to take investment action upon the release of new information, and whose decisions influence the decisions of others.

Studies have shown that information cascades tend to be greater for stocks when reliable and relevant information about the underlying company is not easily available.




Representativeness

Investors assess probabilities of future outcomes based on how similar they are to the current state.



Mental Accounting

Investors tend to keep track of gains and losses from different investments in separate mental accounts.



Conservatism

Investors are slow to react to changes and continue to maintain their initial views.



Narrow framing

Investors focus on issues in isolation

Behavioural Finance

Behavioural finance looks at investor behaviour to explain 

• why individuals make the decisions that they do, 
• whether these decisions are rational or irrational.

It is based on the premise that individuals, due to the presence of behavioural biases:

• do not always make "efficient" investment decisions, or 
• do they always act "rationally" 

These behavioural biases include:

• Loss Aversion
• Herding
• Overconfidence
• Information Cascades
• Representativeness
• Mental Accounting
• Conservatism
• Narrow Framing

Whether investor behaviour can explain market anomalies is a subject open to debate.

• If investors must be rational for the market to be efficient, then markets cannot be efficient.
• If markets are defined as being efficient, investors cannot earn superior risk-adjusted profits consistently. 

Psychology and Investing

You must have faith in your own research, rather than in luck.

Your actions are derived from carefully thought out goals, and you are not swept off course by short-term events.

You understand the true elements of risk and accept the consequence with confidence.

In the business world, you can find huge predictable patterns of extreme irrationality.

This is not talking about predicting the timing, but rather the idea that when irrationality does occur, it leads to predictable patterns of subsequent behaviour.

You should pay serious attention to the intersection of finance and psychology.

The majority of investment professionals have only recently paid serious attention to this.

Your own understanding of this will be valuable in your own investing.

The Psychology of Investing. Emotions affect people's behaviour and ultimately market prices.

The emotions surrounding investing are very real.  These emotions affect people's behaviour and ultimately, affect market prices.

Understanding the human dynamic (emotions) is so valuable in your own investing for these two reasons:

1. You will have guidelines to help you avoid the most common mistakes.
2. You will be able to recognise other people's mistakes in time to profit from them.

We are all vulnerable to individual errors of judgement, which can affect our personal success.

When a thousand or a million people make errors of judgement, the collective impact pushes the market in a destructive direction.

The temptation to follow the crowd can be so strong that accumulated bad judgement only compounds itself.

In this turbulent sea of irrational behaviour, the few who act rationally may well be the only survivors.

To be a successful focus investor:

• You need a certain kind of temperament.
• The road is always bumpy and knowing which is the right path to take is often counterintuitive.
• The stock market's constant gyrations can be unsettling to investors and make them act in irrational ways.
• You need to be on the lookout for these emotions and be prepared to act sensibly even when instincts may strongly call for the opposite behaviour.
• The future rewards focus investing significantly enough to warrant our strong effort.

A little COMMON SENSE goes a long way to Improve Investment Results! The mistakes of some investors may be the profit opportunities for others.

Investors' decisions are affected by a number of psychological biases that lead investors to make systematic, predictable mistakes in certain decision-making situations.

These mistakes, in turn, may lead to predictable patterns in asset prices that create opportunities for other investors to earn abnormally high profits without accepting abnormally high risk.


Here are some of the behavioural factors that might influence the actions of investors:

1.  Overconfidence and Self-Attribution Bias
2.  Loss Aversion
3.  Representativeness
4.  Narrow Framing
5.  Belief Perseverance
6.  Familiarity Bias


Using Behaviour Finance to Improve Investment Results

Studies have documented a number of behavioural factors that appear to influence investors' decisions and adversely affect their returns.

By following some simple guidelines, you can avoid making mistakes and improve your portfolio's performance.

A little common sense goes a long way in the financial markets!


1.  Don't hesitate to sell a losing stock.

If you buy a stock at $20 and its price drops to $10, ask yourself whether you would buy that same stock if you came into the market today with $10 in cash.  

If the answer is yes, then hang onto it.

If not, sell the stock and buy something else.


2.  Don't chase performance.

The evidence suggests that there are no "hot hands" in investment management.

Don't buy last year's hottest mutual fund if it doesn't make sense for you.

Always keep your personal investment objectives and constraints in mind.


3.  Be humble and open-minded.

Many investment professionals, some of whom are extremely well paid, are frequently wrong in their predictions.

Admit your mistakes and don't be afraid to take corrective action.

The fact is, reviewing your mistakes can be a very rewarding exercise - all investors make mistakes, but the smart ones learn from them.

Winning in the market is often about not losing, and one way to avoid loss is to learn from your mistakes.


4.  Review the performance of your investments on a periodic basis.

Remember the old saying, "Out of sight, out of mind."

Don't be afraid to face the music and to make changes as your situation changes.

Nothing runs on "autopilot" forever - including investment portfolios.


5.  Don't trade too much

Investment returns are uncertain, but transaction costs are guaranteed.

Considerable evidence indicates that investors who trade frequently perform poorly.




Implications of Behavioural Finance for Security Analysis

Behavioural finance can play an important role in investing.

The contribution of behavioural finance is 

• to identify particular psychological factors that can lead investors to make systematic mistakes, and 
• to determine whether those mistakes may contribute to predictable patterns in stock prices.

If that is the case, the mistakes of some investors may be the profit opportunities for others.

See the above 5 common sense rules on how to keep your own mistakes to a minimum.

Charlie Munger on Thinking errors and Misjudgements (Summary)

Summary:

Do we behave to environmental stimuli like ants?

1.  Reward and Punishment Super-response Tendency 

(Incentive and disincentive-caused bias.  It is imperative to understand the role of incentives and disincentives in changing cognition and behavior. The power of incentives can be used to produce desirable behavioural changes.  An incentive-caused bias can tempt people into immoral behaviour.  If you rip apart any system and look at its core design, you will find mainly two things: incentives and disincentives. Communism has failed due to the absence of exactly those incentives. The US financial crisis was an outcome of wrong incentives and absence of disincentives.   It is quite clear that man responds more often and more easily to incentives than to reason and conscience. )

2.  Liking and Loving Tendency 

(This tendency to love has its own set of side effects.  Don't fall in love with your stocks.  Fall in love and protect your capital.  Be a disciplined value investor!)

3. Doubt-avoidance Tendency

(Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity.  When neither under pressure nor threatened, a person should ideally not be prompted to remove doubt through rushing to some decision.)

4.  Inconsistency-avoidance Tendency 

(We tend to filter away any piece of information which may be inconsistent with our ideas and beliefs.  Be disciplined with your approach:  play the devil's advocate or have processes and procedures in place that tend to minimize hasty and biased decision making.  Adjourn your stock purchases till you are sure.  Stock markets will always keep swinging higher and lower.  Investing opportunities will be there.)

5.  Envy and Jealousy Tendency  

(Greed is fuelled by envy.  Everyone is here not just to make money, but to make more money than what the next person is making.  Comparison and competition are intense, creating a perfect recipe for jealousy tendency.  The important point to take home is to not let such negative emotions affect your investment decisions. Avoid discussions that would trigger feelings of jealousy.  Keep extremely low profile and keep discussions to stock ideas and business fundamentals.)

6.  Over-optimism tendency  

(Excess of optimism is the normal human condition.  "What a man wishes, that also will he believe."  The best way is to acknowledge that this bias exists in the first place.  Challenge your views by asking yourself as many questions as possible to see if your views can stand the attack of reason.)

7.  Social proof tendency

( It is an automatic tendency to think and act the way people around you are thinking and acting.  The evil of corruption continues to persist because of the Serpico Syndrome, which is created by the social proof tendency and the power of incentives.  It dominates how investors behave in stock markets, how company managements (institutional imperative) do business and so on.  Have the management act as if they were the owners.  Buffett says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.)

8.  Contrast Misreaction Tendency 

(We perceive everything in relative terms.  It influences how we think about economic news and information, corporate performance, stock prices and so on.  Contrast misreaction cause people to make wrong judgements based on misleading contrasts between two or more things and situations.  For example, a person shifting to another city and looking for a new house and his estate agent using this trick on him.  For the investor, why he did not buy the stock at 140 (because it rose from 90) and then he bought the same stock at 300 (because it fell from 450)?  A stock with P/E of 50 in past and is now at P/E of 30 does not mean it is a lucrative buying opportunity.  Look at the company's business fundamentals and its past financial track record.  Valuing the company based on such important parameters will help you avoid false comparisons.)

9.  Availability-misweighing Tendency  

(Due to the relentless flow of news and information, the human mind has a tendency to focus on what's easily available.  In doing so, often tend to give undue importance to it.  In the absence of relevant information, investors often end up giving undue importance to such insignificant matters.  Adopt Charles Darwin's approach.  He would try to gather evidence to disconfirm it.  Challenge the merit of the idea.  Look for potential risks and concerns that could adversely affect the company.  The ultimate investing decision should be based solely on your understanding and insght and not from borrowed optimism.  Be discipline.  To avoid falling prey to this tendency is to prepare an investment check list and adhere to the process in a disciplined manner.)

10.  Use-it-or-lose-it Tendency  

(The importance of regular practice is especially very vital in skills of a very higher order.  Many people take investing as a side business which can be done without putting in too much time and effort.  And that is one of the biggest fallacies.  Legendary investors such as Warren Buffett, Charlie Munger and Peter Lynch did not create great fortunes out of thin air. They are known to be rigorous practitioners of their art.  They all read extensively and spend a huge amount of their daily routine analysing companies.  By using their mental skills meticulously, they have become successful pilots of the investing world.)

11.  Senescence-misinfluence Tendency  

(At an age when you may not be in the best physical frame to travel distances and perform demanding tasks, what could you do for an alternative source of income?  The answer is investing.  The real risk of significant losses lies in speculative short-term trading.  If you choose the path of long term value investing, you will not only live with minimal risk, but the chances of immense profits will be significantly high.  Remember, in the long run, equities tend to outperform all major asset classes.  If you develop useful skills early in your life and practice them rigorously over the years, you could manage to retain those skills for a much longer period, despite the aging process.)

12.  Authority-misinfluence Tendency  

(Uncertainty and risk have a big influence on how independently people take their decisions.  This makes the stock market a place that is incurably afflicted by the authority-misinfluence tendency.  Just spare a moment and ponder about how exactly you decide when to buy or sell a stock.  What makes you follow these experts?  It is important that you exercise your own independent judgement to the opinions of others.  "Mr. Market is there to serve you, not to guide you."  The greatest investors in the world are those who do not give in to the moods of Mr. Market.  (Mr. Market is a parable told and popularised by Benjamin Graham, teacher of Warren Buffett.)

13.  Twaddle Tendency  

(Man often indulges in petty small talks and chatter.  They only become a nuisance when they come in the way of some serious work that is in progress.  This twaddle tendency, like the twaddle dance of the honey bees, can lead to unproductive results.  And this is what we need to keep a check on.   Better to stay in a quiet corner meantime rather than doing something silly, irrelevant or unproductive.)