Investors are rational and make sound decisions based on facts and intricate calculations. Well, that’s the theory. Reality is infinitely more complex. We all have tendencies to deviate from rational decision-making. Recognizing and overcoming your investment biases will lead you to better results.
Our investment biases cause us to make cognitive errors or give in to our prejudices or inclinations. Some of our biases are based on our emotions. Others are due to our brain having learned to cut corners to analyze the millions of data points it’s exposed to every day. Over the years, our brains created patterns. It directs information toward conclusions that are based on older data stored. Since your brain doesn’t consider all data when it’s time to buy or sell a position, it can lead to terrible investing decisions.
Understanding these investment biases will help you develop the intuition to pause and take another look at a situation before pulling the trigger. Here, we look at two biases: the confirmation bias and the herding bias.
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Confirmation bias
When we believe in something, we tend to favor information that confirms this belief, while disregarding information that contradicts it. We enjoy finding people who think like us and avoid those who challenge our thoughts and beliefs.
For example, if I judge that Apple (AAPL) is an amazing company, I’ll likely assign more credibility to an investing firm telling the world this stock should trade at over $200/share than the one saying AAPL is at risk because the iPhone sales cycle will end. If you think Target (TGT) will beat Amazon (AMZN), you’ll probably find bloggers and analysts telling you that TGT is a strong dividend king and ignore articles saying you the opposite. An investor convinced the market is going to crash will only ready or give credence to news stories supporting that conviction.
This behavioral bias affects all spheres of our lives. We look for information and people in line with what we already believe. Our initial belief is reinforced by that new information, and we have more conviction in our decision. Now, having confidence in your decisions is a good thing. Drowning in doubt is unpleasant and can leave us paralyzed, unable to act.
However, repeatedly confirming your belief with new information makes you blind to other investing theories and beliefs. When you are confident about an investment, stop reading stories confirming your decision.
Overcome the confirmation bias
Here’s what I do. After writing my investment thesis focusing on all the great things a company does and why I should buy it, I take a break. A day or two to let that sink in and let the hype go down. The stock will still be available to buy next week!
Then, I add a potential risk section to my investment theses. Knowing what could go wrong with the company is a lot more important than what it does well. To write about potential risks, I search for bearish cases on the internet. I usually start searching with Morningstar and Seeking Alpha, but I also look on YouTube and podcasts and now use ChatGPT to help me narrow down all the risks.
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Herding bias
If most investors around you agree that Johnson & Johnson (JNJ) is a great dividend stock that should be part of any dividend portfolio, you might find it difficult 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.
This is the herding bias. Individuals follow the actions or opinions of a larger group or group of experts, often disregarding their own analysis or opinions. The error here is assuming that the majority is correct. We also fear missing out on potential gains. Oddly, we see that bias even with professionals!
Noise can influence investors very negatively. Whenever market news about a company or a market event gets traction, it creates a global consensus in the media. In early 2021, many discussed a possible deep bull market in the oil industry. As the economy recovered, the oil demand began ramping up. Then, we noticed the lack of investment in exploration/production over the past few quarters.
This narrative became the consensus that we will need more oil for a longer period. It pushed experts to claim that the oil barrel would hit $100 and go beyond. Fast forward to 2024, the oil barrel is still stuck bouncing up and down between $70 and $90 but we are far from trading above $100. Did we increase oil production that much in such a time? Or was it just that the experts were themselves biased into driving a bullish narrative around oil? I remember reading the same narrative (and the same consensus toward oil) after the market crash of 2008-2009…
Overcome the herding bias
Shutting down the noise is a challenging exercise, especially when everybody is singing the same song. It’s easy to pick up someone’s idea but you can’t pick up his conviction. For this reason, I tend to stay away from “trends” in the market by default.
When everyone invests in one direction, I keep my asset and sector allocation intact. It happens that my portfolio is aligned with what people think, but it’s not by design. By keeping the same strategy and the same allocation, I reduce my risk and exposure to a single event.
My sector allocation is decided by:
- My investment goal; I want dividend growers, potentially more low-yield, high-dividend growth stocks
- My level of knowledge: The largest sectors in my portfolio are those I understand the best
When everybody thinks we should invest in tech stocks and I have some of them in my portfolio, that part of my holdings usually performs well for a while, because demand for the stocks drives prices up. However, I won’t increase my exposure to this sector simply to follow the herd.
Again, know what you own and why you own it.
We’ll explain other investment biases over the next few weeks.
