Investment Biases: How Your Brain Is Playing Tricks (Part I)

"Emotions taint our judgment and have us do things that don’t really make sense."
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Since I was eight years old, I have always been passionate about numbers. I first wanted to become an accountant, but I quickly got bored by the infinite numbers and columns with which I had to deal with routinely. I then pursued a bachelor’s degree in marketing which was infinitely more fun. Halfway through my collegiate years, I secured a job in the back office of an investing firm. I was clearing options and futures transactions. When I discovered this crazy world (where you can trade pork bellies!), I knew exactly what I wanted to do in life and that was to work around the financial markets. I’ve always been captivated by how markets evolve in various directions for various reasons. Therefore, I completed a bachelor’s degree with a double major in both marketing and finance.

When I did my financial classes, everything seemed so well organized and rational. Financial theories are so straight forward and comparatively easy to understand. It’s almost impossible to mess up the applications in the real world, or is it? Investors are supposedly rational individuals making sound decisions based on facts and intricate calculations. Well, that is the theory behind what is being written in many financial books.

Unfortunately, the truth is significantly more complex. Emotions taint our judgment and have us do things that don’t really make sense. Since it is very hard to control our emotions, I thought it would be interesting to read about certain investment biases so it might ring a bell with my readers when such a situation occurs. At least, you may have or develop the intuition to take a pause and take a second look at a specific situation before pulling the trigger.

Not all biases are based on emotions. Our brain must deal with millions of data points each day. Therefore, it has learned to cut corners to make its analysis process faster. Our brain will create patterns and direct information towards conclusions that are based on data that was previously stored. This would lead to terrible investing decisions as your brain won’t take all data into consideration when it’s time to buy or sell a position.

We all know about common investor biases, but we tend to forget about them at times when things are going too well, or at other times when things are going downhill. This is the first of a two-part article about the most important investors’ biases and how you can avoid making mistakes caused by those biases which we all possess.

Confirmation Bias

When we believe in something, we tend to give it more credibility and more weight as we accumulate data, research and opinions confirming that belief. On the other hand, we may tend to ignore or diminish the value of research and opinions that go against our belief. This is because we like to find people that think like us and disregard people who challenge our thoughts and beliefs.

For example; if I determine that Apple (AAPL) is an amazing company, I will likely assign more value to an investing firm telling the world this stock should be traded over $400 per share instead of another firm explaining why AAPL is at risk.

This is a behavioral bias that applies in all spheres of your life. The confirmation bias is the tendency to look for information or people confirming what you already believe.

This totally makes sense. You would not hangout with people who always tell you that you are wrong. Hanging out with people having the same mentality and beliefs will reinforce yours and makes you feel better. I rarely see a vegetarian hanging out with intense steak fans.

The same bias happens all the time in the investing world. If an investor is convinced the market is going to crash, the only news he will read or give credence to are the stories supporting his conviction. The financial market is a widely discussed topic across the internet and the media. For example, if you think Target (TGT) is going to beat Amazon (AMZN), you will most likely find bloggers and analysts telling you that TGT is a strong dividend aristocrat and you may choose to ignore my articles on the topic.

Consensus Bias

If most investors in your environment agree that Johnson & Johnson (JNJ) is a great dividend stock and should be an integral part of any dividend portfolio, it may be hard to go against the crowd. The truth is, JNJ might not be such an amazing stock, but it “becomes one” since everybody is going in the same direction. Strangely enough, we see that bias even with professionals!

We saw a great example with Tesla (TSLA) in 2020. A massive number of retail investors rushed into this stock in 2020. You can see how many different Robinhood accounts hold this new darling:

We could conclude to a similar bias in the meme stocks events. So many retail investors are convinced that $GME or $AMC are going to surge that the buy volume alone pushes price higher up. We have not yet see how this story ends.

Regret Aversion / Loss Aversion Bias

This one is well known as we all know that it hurts more to lose $10,000 than it feels good to make $10,000. Go figure-we are just that kind of animal!

I think this may be the most powerful bias an investor faces: the pain of losing money is greater than the joy derived from making money. Now that the market has fully recovered from the March 2020 crash, investors who have cash on the side will likely wait “for the next dip” as the apparent outcome of entering the market at peak levels could generate severe losses.

In general, as the market recovers, investors are more and more concerned about losing their money in the coming months. They expect the market to fall any day and would rather wait on the sidelines. This is especially true when the market hits record highs. Because if you are about to invest $100,000, you may rather earn $100 in the next month than risk losing $10,000.

Unfortunately, nobody knows what will happen in the future. Therefore, this kind of thinking is completely non-productive. I remember that when I invested the commuted value of my pension plan in 2017, we were at the market’s all-time high and a crash was also “imminent”. Imagine if I had waited on the sideline!

The loss aversion is often combined with choice paralysis. Choice paralysis comes when there is an overload of information that hinders the actual decision process. As you research to know if we are getting close to a market crash, you will be reading a lot of contrasting articles. Some will tell you that the market can’t go any higher. Others will show you how much they made in the last months. The more you read, the less you act.

Finally, regret aversion is also responsible for some investors keeping their losing stocks forever. Once the paper loss is digested, investors are wiling to wait until they recover that loss. They would rather wait than sell their losers and subsequently possibly see them go back up the next year. Again, meme stocks are not helping investors to let go of their losers. Imagine you are holding the next GameStop (GME)?

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Stay tuned for Part II next week...

Next week, I’ll cover three other biases (hindsight, recency and my favorite one… to be told next week!). We will also discuss a few tricks on how you can reduce/control those biases to make sure you don’t fall into their traps.

Cheers,

Mike Heroux, Passionate Investor & founder of Dividend Stocks Rock

P.S. Are you concerned by the current state of the market? Download my free DSR Recession-Proof workbook and make sure you don’t suffer during the next market crash.

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**Please do your own due-diligence before investing in any stocks we discuss in this article**