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

I’m closing this two part series with my “favorite” bias along with tricks to overcome the short-cuts your brain built in your investment process.
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Last week, I’ve covered several investment biases. Today, I’m closing this two part series with my “favorite” bias (guilty as charged!) along with tricks to overcome the short-cuts your brain built in your investment process.

Hindsight Bias

The hindsight bias is what we refer to as “playing Monday morning quarterback”. When you look at what happened in the past and you find obvious reasons to explain how the market evolved. Have you ever noticed how everything is so obvious when you look in the rear-view mirror?

Everybody should have known the market would crumble back in January as the virus was spreading everywhere!

Everybody should have seen the financial crisis coming.

Everybody should have purchased Amazon and Shopify 10 years ago because the future of retail is online!

Everybody should have ignored the Blackberry devices as it was obvious Apple would crush them!

Strangely enough, when you look at the present and you try to predict the next 3 months, nothing is clear now.

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Anchoring and Recency Bias

When you build a theory in your mind, your brain will tend to rely heavily on a handful of facts or data which supports your belief. Holding shares of Macerich (MAC) relying on the fact it was once worth $90 a share (now more like $9 a share). Thinking the stock market is going to collapse and never come back by citing Japan or calling for stagflation as you remember the 70’s is also great example.

If you look at your portfolio and you constantly think of the 70’s, you will sell a good chunk of your stocks and you will buy gold as you are convinced the yellow metal will make another 900% run. You will ignore that which happened in the 70’s was due to a particular context (which is far from the one we have now) and you will focus on the “high probability” of seeing gold prices continue their upward trajectory. Since gold is on its way to doubling its value in 5 years, why not imagine a run where it finishes around $7,000 in 5 more years?

Like anchoring bias, there is the recency bias. Looking at the past 10 or 20 years to draw conclusions may also lead you in the wrong direction. The recency bias tends to give more weight to recent events compared to what happened a long-time ago. Since there is a limit of information our brain can process, keeping in mind the last important events is often enough to shape an opinion.

As the economy is in constant evolution (nobody used the expression cloud services back in 1999!), it’s important to consider recent history. However, ignoring how similar crises were handled in the past could also cost you a lot. When you look at the big picture, history does in fact tend to repeat itself almost indefinitely.

Overconfidence and Self-Attribution Bias

Overconfidence is probably a bias we are all guilty of having from time to time if we choose to manage our own portfolios. As an individual investor, we believe we have an edge on others. We believe we have a unique ability to understand the market a little better than anybody else. We don’t have to think we are geniuses; we just must believe that we are better than the average bear.

Then, when we buy shares of Brookfield Property Partners (BPY), we believe Brookfield is the best Real Estate manager on the planet. We think their assets are better than gold and that their stock price will come back (a mix with anchoring bias!). The fact that Brookfield is now in our portfolio makes us think it’s getting better every day.

The self-attribution bias is slightly different. This is where all success is attributed to our magnificent ability to read the market while all failures are caused by external (and impossible to predict) causes. This protects our ego (so we can feel confident again) while denying any flaws. This could be highly counterproductive if you can’t own your decisions.

A bit more about my story

Back in 2006, I became a bit too overconfident. After three years of successful trading experiences, I started to think I was “made for this”. After all, I made money on almost all stocks I traded back then. What I ignored is that a monkey had equal chances of making money between 2003 and 2006.

I’ve suffered from self-attribution (thinking I was brilliant and not realizing I surfed a bull market) and use this sentiment to boost my confidence (as if I didn’t have enough already). Therefore, I started taking more significant risks. I invested a larger amount in more speculative plays. After a few profitable trades, I was about to cash everything in to buy a house. I thought, “why not adding a BMW in front of my new house?”.

You guessed it: this story ends badly. I lost a significant amount of my cash down on a stupid trade and ended up borrowing money from my parents to purchase the house. Today, I still have a tendency of being (too) confident when I invest. However, I now focus on my investment plan and trust the process rather than taking additional risks on speculative plays!

What is the ultimate solution against investment biases?

There is an effective weapon to aid in eliminating most investment biases. You may have seen this coming, but it is the presence of an effective investing strategy. At DSR, we cannot stress enough the importance of having a clear and straightforward investing strategy. In an ideal world, you would write your process down and refer to it each time you review your portfolio. If you need help defining your investing strategy, you can download our DSR recession-proof workbook. Here is how each bias can be overruled by your investing methodology.

Regret aversion / loss aversion bias: Having a plan including a long-term investment horizon will help you understand the impact of a market crash on your retirement. While doing financial projections, you can include a market crash every 10 years or so. The question is not if you will live through a bear market as you already know it will happen more than once over your career as an investor. By understanding the impact of a double-digit drop of your portfolio value, you will see how many years it takes to recover and if it really affects your retirement plan or not. You can also reduce your projected investment returns by including bearish markets in your analysis.

We are all worried about investing at a bad time. But when you look at the results though long-term goggles, you will see that even if you invested all your money in 2007, it was still a good decision:

Source: Ycharts

Source: Ycharts

Confirmation bias: In our DSR June 2020 newsletter (The DSR Buying Process), we highlighted the importance of reading bearish investment theses on companies you are about to add to your portfolio. Throughout your analysis process, you may become extremely interested in a company and find only the positive points. Looking for bearish factors will bring you down to earth and reduce your confirmation bias. The potential downsides section of our DSR stock card is an ideal tool for countering this bias.

Consensus bias: The technique to discarding this bias is like that of the confirmation bias. You need to understand both sides of an investment thesis. Confirming your investment decisions by using the majority as an argument is simply not valid.

Hindsight: Here’s a simple rule: never try to replicate what has already be done. Each situation is unique. What happened in the market 10 years ago happened in a specific context. This context has changed today, and we don’t know how a similar event will affect our investments. By sticking to your plan regardless of all the noise, you will create an easily predictable ending. You will enjoy your retirement!

Anchoring and recency bias: The remedy for both biases is to integrate several metrics, factors and contexts into your analysis. You can’t stick to a previous stock price to confirm your holding decision, and the Spanish flu is no excuse to explain COVID-19, nor does the recent bull market justify your strategy. By opening the scope of your research, you will get a better understanding of the current situation.

Overconfidence and self-attribution bias: When my portfolios increase in value, I usually stay humble and thank the quality of my investing process. In other words, I “trust the process”. When my portfolio goes down, I acknowledge my potential losses and try to define where I went wrong. Once I have reviewed my investment thesis for each holding, I go back to my golden rule… “trust the process”.

Which Bias is Your Worst Enemy?

Throughout my 17 years as an investor, I’ve experienced many biases. Fortunately, I have devised methods to diffuse most of them and I’m then able to make more rational choices. Unfortunately, this must be an everyday process. The simple act of acknowledging our biases makes us a better investor. Our brain will always try to find shortcuts and it’s our responsibility to take a pause and think twice before acting.

Having a detailed investment process written down helps in staying focused and sticking to the plan. If you have given enough thought to the writing of your plan, you can then manage most biases by simply reading your plan over and over again and thereby staying focused on the prize – a happy retirement.

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**

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

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