Don’t Let These Investing Biases Cause Your Returns to Slip
Aside from the recent concerns over the impact that a Coronaviris pandemic will have on global markets, stock markets all over the world, and more specifically in the US, have continued to make new all-time highs.
If you were invested in ANYTHING last year, you made money – and likely a higher than average return regardless of what you invested in. Everything went up!!! But as stock markets in the US continue to hover near all-time highs, investors should be wary of certain investing biases before deciding to stay invested or chase returns that are in the past.
This is the idea that investors presume that recent patterns can be extrapolated forward indefinitely – in this case, an upward sloping stock market price line. Investors with recency bias view recent performance as the most important determinant of future performance, which in 2000 and 2007 resulted in big mistakes for anyone that remained overweight to equities.
This behavior occurs when investors assume that their prior forecast is still valid despite new information to the contrary. It would be similar to believing that it won’t rain today because it didn’t rain yesterday, even as dark clouds begin to slowly roll into view. It is somewhat similar to Representative Bias in that the perceptual framework being used to process new information does not give enough weight to data that isn’t consistent with an investor’s projected outcomes.
This might currently be the most prevalent bias among investors. After 10 years of positive returns (2019 had a slightly negative return due to market losses in December), investors might be feeling good about their ability to pick winning stocks. Nothing could be further from the truth. As I mentioned earlier, everything has gone up, so positive performance is not indicative of investment talent. Yet an investor with this bias is likely to believe their success is entirely due to their stock picking, and the performance of any stock that declined would likely be blamed on a random external factor.
This investing bias occurs when investors seek out information that confirms their views or investment decisions while ignoring information that contradicts them. Rather than have a well-rounded view of an investment, an investor with confirmation bias piles up on articles, research, and data that is one-sided.
This investing bias is comparable to Self-Attribution bias but differs in that while Self-Attribution bias is linked to innate abilities, overconfidence bias is more closely linked to an overestimation of judgment. Neither of them are healthy for long-term investment success.
This investing bias was once evident in Apple investors who related to the Apple brand so heavily it influenced their opinion on the stock as an investment. There is no arguing Apple is a fantastic brand with a cult-like following. But that fact itself leaves out fundamental aspects of the company, the competitive environment, growth expectations, etc. The Apple affinity is still strong but a more popular Affinity Bias seems to be prevalent among Tesla investors, which have driven the stock up by 308% in just 6 months. While the recent surprise in profitability should have had a positive impact on the stock price, there are many expert analysts that wonder whether the price spike has been overdone. The recent price increase, therefore, might have more to do with Affinity Bias and the attraction of Elon Musk as a billionaire defiant leader with a vision, not necessarily the value of the company itself.
One of my most dreaded investing biases. This bias is when investors base an investment decision on past performance without giving much thought to how that performance was generated. The performance of momentum funds versus quality funds is a good example. If we look back at periods of Momentum outperformance, it is likely to be driven by a strong bull market and capital chasing opportunities to make outsized returns. To assume that Momentum stocks will continue to outperform during a less sanguine market is a result of Outcome bias – that is, not paying attention to the fact that Momentum stocks outperformed due to external drivers that are no longer present.
A more prudent analysis might lead an investor to tactically allocate to a High Quality strategy, which tends to outperform Momentum when times get tough. I mentioned this is my most dreaded bias because clients often question why you add certain positions to their portfolios that have not performed well in the recent past. Only after explaining to them that the drivers of their underperformance have reversed and are now acting as a tailwind do they reluctantly agree. That is, if I can get them to overcome Recency bias to acknowledge that the recent pattern will not continue forever.
Leave Investing Bias Out of Investment Decision-Making
As I mentioned in a previous article, most average investors underperform a passive buy and hold strategy, primarily because of psychological challenges and the lack of an investment process that keeps them disciplined. To become a better investor, we must be aware of these biases and implement some sort of check and balance to make sure we don’t make mistakes because of them.
With markets recently swooning due to fears of the spreading threat of Coronavirus, investors should dig deep to determine if prospects for their current holdings are still positive long-term. If they are, there is no need to panic-sell when markets get volatile, but if there are implications that could affect a company’s or country’s long-term growth prospects, then investors should evaluate the possibility of selling.
If you have a process in place, stick to the process. If you don’t, it might be time to put one in place.