—  BEHAVIORAL FINANCE  —

We all have behavioral biases. Here’s how to protect yourself from you.

It’s often said that we can be our own worst enemy. It’s human nature to overthink things, to overlook new information and to seek out views consistent with our own. I’m here to say not to worry, this is completely normal and that by simply having knowledge of your biases can instantly make you a much better investor. In this section on behavioral finance, I will present to you 20 of the most common biases we have, how they may affect your investment decisions, and what you can do to protect yourself from you.

—  ANCHORING —

Price does not equal value. Don’t get anchored to it.

Anchoring bias is one of the most common behavioral biases investors exhibit today, so it’s only appropriate to start with it. Anchoring bias is when a person relies too much on previously known information to make subsequent decisions. The piece of information we “anchor” to is often the first or more recent piece we come across.

Investors can get themselves into trouble when they assign a value to a particular security based on something as arbitrary as price. We must understand that price goes up and down all the time and is a poor proxy for how well the investment will perform in the future. Even with seasoned investors, a common mistake I see is “waiting” for the price to drop a certain number of percentage points before buying. It makes just as much sense to “wait” for the price to rise by a certain number of percentage points before selling. Price is not a very good measure of value and should not influence your investment decisions; what you should be focusing on are industry and company fundamentals, the experience and vision of the management team, and other factors which help make up an investment thesis.

Suppose you are really hoping to purchase shares of Royal Bank because you really believe in the company’s future and are looking to increase your exposure to big bank stocks. You’ve analyzed the company thoroughly, but are reluctant to purchase shares today because they were $5 cheaper several months ago when you first started your analysis. By doing so you feel like you’re not getting a good deal, so you wait. And you wait, and you wait. But six months later the shares have increased by another $5 and now you don’t know what to do. By hesitating after your thorough analysis, you have now put yourself in a position where you either have to walk away from a good investment, purchase the shares at a higher price, or wait even longer on the hopes the price will be reduced. Of course you may be right from time to time, but isn’t it more likely price would go up if your analysis was correct?

The point is that price is arbitrary, and is only a snapshot of what an inefficient group of market participants have decided is fair at any given time. Price is a dependent factor, not an independent factor. That is to say that price is the result of all the things that go into what you’re being charged for a share and not the other way around. It’s arbitrary, so try and put it out of your mind when deciding when to buy or sell.

—  AVAILABILITY—

Don’t make an investment just because you can.

Have you ever purchased something just because you can? Of course, we all have and probably do on a daily basis, but it’s mostly for routine purchases. We may stop in at our local coffee shop on our way to work, pick up a case of beer on a Friday night, or let our kids rent a movie on Disney+. These things aren’t likely to disrupt your financial future too much, but what about doing the same thing with your investments?

Imagine yourself standing in line at your bank and you see a poster for the bank’s Education Savings Plan. It reads something along the lines of investing just $25 per week will result in $50,000 in 18 years, with some fine print identifying the assumptions made in that calculation. So you go see the teller, perform your transaction and ask to see an investment representative to get you started on the Plan. What have you just done? Exhibited Availability Bias.

When people make important investment decisions simply because someone or something is making it easy to do, the results can be disastrous. With availability bias, the person ignores the fact that there are very many other competing products available to them and that there’s a very good chance that the product they have chosen is not the best solution for them. Availability bias results in the person being tricked by clever marketing and while it’s not a big deal for routine daily purchases, it is when it’s your family’s financial future at stake.

—  ambiguity aversion —

Is an investment bad just because you don’t understand it?

Ambiguity aversion is when a person becomes paralyzed from making decisions when they are unsure about its distribution probabilities. In reality, we always have some doubt about how an investment will perform, but it’s normal to be afraid of investing in something you don’t understand.

As investors, luckily we don’t have to have a complete understanding of the factors at play before making a decision. We have the liberty of creating various tranches of investments such as having core, less-risky assets which we understand well and speculative, highly risky assets which we don’t have good knowledge about. Ambiguity aversion may cause you to miss out on great investments when the actual return-risk ratio is quite attractive.

—  confirmation bias —

The market doesn’t consider your opinion. Nor that of your friends.

Confirmation bias is the tendency to seek out or emphasize information which conforms to their beliefs or worldview, and is one of the most common biases people in all aspects of life tend to exhibit. A “tool kit” designed by legendary astronomer Carl Sagan suggests the following point, among others:

Try not to get overly attached to a hypothesis just because it’s yours. It’s only a way station in the pursuit of knowledge. Ask yourself why you like the idea. Compare it fairly with the alternatives. See if you can find reasons for rejecting it. If you don’t, others will.

Those “others” are of course other market participants. It’s wasted time and energy seeking out opinions on stocks and bonds which validate your own and using that to justify an investment. It’s perfectly fine to come across and discuss similar viewpoints and feel good if a trusted person has come to the same conclusion as you, but if that person isn’t challenging that viewpoint then it is flawed. Try and take the opposing view, see if any short-sellers are covering the stock, and ask as many questions as you can.

As investors, luckily we don’t have to have a complete understanding of the factors at play before making a decision. We have the liberty of creating various tranches of investments such as having core, less-risky assets which we understand well and speculative, highly risky assets which we don’t have good knowledge about. Ambiguity aversion may cause you to miss out on great investments when the actual return-risk ratio is quite attractive.

—  conSERVATISM bias —

Don’t cling to the past. Always be willing to accept new information.

Conservatism bias is when we fail to acknowledge new information or forecasts and choose instead to cling to previously held favorable views about something. Consider a situation where an investor has purchased a stock based on the unanimous buy recommendations of her favorite analysts. Six months later after some mixed earnings reports, two analysts downgrade their price targets but still maintain buy recommendations. An investor exhibiting conservatism bias would still cling to the idea that the buy recommendations are unanimous, and not put much weight in the fact that the overall outlook is more negative.

Conservatism bias becomes especially hard to deal with when the latest information is complex. The easy way out is to just ignore it, but you must make a best effort to try and understand it as best as you can to avoid falling into this common trap.

—  ENDOWMENT bias —

Something isn’t more valuable just because you own it.

Think about this. If something is valued correctly, shouldn’t your willingness to buy something at a certain price be the same as your willingness to sell at that same price? That’s what standard economic theory says at least, and endowment bias arises when we assign a higher value to something just because we own it. This happens all the time to investors and may result in them holding on to a stock for too long or ignoring opportunities elsewhere in the market.

The reasons for endowment bias are numerous, but one of the most common reasons is because an individual has some sort of connection to the stock. If you do your banking with TD or if you do your grocery shopping at Loblaws, you are likely to feel more emotionally connected to these companies and thus, put a higher value on them than maybe you should. From Investopedia, a fun little experiment is described:

A college professor who teaches a class with two sections, one that meets Mondays and Wednesdays and another that meets Tuesdays and Thursdays. The professor hands out a brand new coffee mug with the university's logo emblazoned on it to the Monday/Wednesday section for free as a gift, not making much of a big deal out of it. The Tuesday/Thursday section receives nothing. A week later, the professor asks all of the students to value the mug. The students who received the mug, on average, put a greater price tag on the mug than those who did not. When asked what would be the lowest selling price of the mug, the mug-receiving students quote was consistently, and significantly, higher than the quote from the students who did not receive a mug.

The lesson here is to be realistic about the value of a stock and ignore whether or not you own it. Try and be fair and objective, and approach your comparisons as if you don’t have a position in any.

— FRAMING bias —

We gravitate to positively-framed questions, and shun pessimistic ones.

In The Adventures of Tom Sawyer, a mischievous Tom was punished by his Aunt Polly to whitewash her fence. Tom’s friend Ben began teasing him for having to do such hard work, but Tom made it seem like it was not work at all. What work, he asked. I don’t see why I would be (upset), you don’t get to do this everyday. And with that, Ben became more interested, even asking: Say Tom, let me paint a little. But Tom refused, goading his friend further by saying: Only one in a thousand, maybe even two thousand boys can do this, and Aunt Polly said this is so important only Tom Sawyer can do it. At the end of it, Tom had Ben and his friends pay him for the privilege of whitewashing the fence.

“To make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.” — Mark Twain

This is the way that framing bias works. If a question or an opportunity is framed in a positive way, we are more likely to select those options as opposed to pessimistically framed questions or opportunities. Any time you are answering a questionnaire or reacting to a company earnings report, there is a framing bias risk. For example, let’s say that a company reported earnings per share of $1.10 compared to last year’s $1 per share and on expectations of $1.21 per share. You go on to read two articles: an upbeat one describing how the company is growing with earnings up 10% over last year, and a negative one highlighting how the company’s earnings missed expectations by 10%. Both are true, but the author framed their article in such a way to get you on their side.

As an investor, watch out for such situations especially around earnings reports. If it’s reported that a company’s earnings beat expectations, ask the simple question: whose expectations? Analysts, the company’s, your own? Also be careful about framing bias when filling out risk tolerance questionnaires - questions may be framed in such a way that encourages you to take on more risk than you should.

— HINDSIGHT bias —

I knew it would happen all along.

We’re all experts when we know the result of something. If we pick a stock and it goes up in value, we sometimes say that we knew it all along. It was obvious to us. The fact of the matter is that it was not obvious, and there were so many other ways it could have played out. Even a company executing its plans perfectly would not be immune to outside forces such as interest rate changes and economic reports.

Rarely do we take the time to think about alternative outcomes if our prediction proves successful. If an oil company goes up in value because the price of oil has increased, do we take a step back and ask ourselves what would have happened if the price of oil decreased instead? Asking yourself these questions and imagining other scenarios is the best way to protect yourself against hindsight bias.

— ILLUSION OF CONTROL —

We don’t have magic powers.

Much like blowing on dice at the casino won’t affect your roll or picking your own lottery numbers won’t increase your chances of winning, you can’t will your investments into succeeding. In fact, the only person who really has a high degree of control over a company’s success is its CEO.

The illusion of control bias leads investors to stick predominantly to industries and fields they are skilled in, which will likely lead to under-diversification and over-trading. For example, if you work for an insurance company and believe you have better insights into the industry, you may find yourself leaning more heavily into insurance stocks than an otherwise objective and rational person would. You may also trade more often, thinking that the information you possess is more valuable than it actually is.

— LOSS AVERSION BIAS —

When it’s time to sell, we don’t sell.

Economists Daniel Kahneman and Amos Tversky’s research taught us that avoiding losing is twice as powerful a motivator as making a gain of equal magnitude. In other words, for every one an investor places at risk, they would demand two dollars in return. Of course this is not rational, and often is the cause of people wanting to “go down with the ship” and not offload a poor investment choice.

Investors displaying loss aversion bias have difficulty coming to grips with their poor decisions, as it can an emotionally difficult thing to do. They often wait to unload these investments, instead preferring to wait until they break even (which may never happen). Even if it does happen, the person has perhaps missed out on better gains with other investments.

— mental accounting —

Your portfolio is greater than the sum of its parts.

Mental accounting happens when investors try and compartmentalize individual holdings rather than looking at their portfolio as one cohesive unit. They may dwell on a 10% loss in a single stock and focus less on the 5% gains a few other securities have returned. Investors may also find themselves having several accounts for separate uses of that money. You may have one buy-and-hold account for retirement, a trading account for speculative investments, and another account set up for vacation money. This is all well and good, so long as the combined portfolio is well-diversified and is designed to accomplish all your goals.

One thing investors should get in the habit of doing is monitoring their asset and sector allocations. Group your accounts together and see where your biggest exposures are. For example, a buy-and-hold account holding only Index ETFs combined with a speculative account full of tech startup stocks is likely going to leave you overexposed to the Technology sector. Unless you take a bird’s eye view of your portfolio, you may never realize this.

— OPTIMISM BIAS —

It’s good to be positive. But bad things can happen.

As human beings, it’s in our DNA to be optimistic. In many respects this is by design, because if we were not optimistic we likely wouldn’t get much done. We also have the tendency to rate ourselves as better than average in most traits. This optimism bias arises when we are too optimistic about outcomes such as believing the stock market will always be rising or underestimating the likelihood of something bad happening.

As prudent investors we must try instead to be cautiously optimistic. If we choose to purchase a stock that is 20% off its highs, we must also consider the fact that there were a lot of other investors who felt the stock was a good purchase and are now down 20%. Daniel Kahneman developed a system called Reference Class Forecasting which can be used to overcome optimism bias.

Reference class forecasting is so named as it predicts the outcome of a planned action based on actual outcomes in a reference class of similar actions to that being forecast.

Kahneman encourages people to take an “outside view” when forecasting results, which includes the actual results of other investors given the same inputs. For example, simply researching how stocks which have fallen 20% off their highs have performed over the following 12 months may give you a better insight. Taking an “inside view”, as we unfortunately often do, shuts the door to valuable distributional information and paves the way for optimism bias.

— OVERCONFIDENCE BIAS —

It’s difficult to accept that we may not be as smart as we think we are.

Overconfidence bias arises when people believe their intuitions and judgments are better than they actually are. What’s more is that not only do they believe they are more intelligent than is warranted, they also believe that the information they have is superior to the information others have. Overconfidence can cause a whole host of problems when investing and is something single males are particularly vulnerable to.

Consider someone who enjoys researching renewable energy companies and they come across a new startup that they are convinced will change the world. They decide to invest, because they tell themselves that it’s only a matter of time before other investors realize what they already know and when they do, the share price will skyrocket. While they may be proved correct, there is also a good chance they’re overconfident. What’s more, they have no idea who they are “competing” against. Are they making trades with company and industry insiders or against unsophisticated investors just looking to make a quick buck? At a minimum, overconfident investors are unsure what information is available to others, so a certain degree of humility would be well-advised.

Overconfidence bias is not to be confused with optimism bias. While optimism bias is emotional in nature, overconfidence is cognitive. While overconfidence bias overestimates one's abilities, optimism bias occurs when we believe something is more likely to result in a favorable outcome.

— RECENCY BIAS —

There’s more to a stock than just its more recent earnings report.

When you go to research a stock, where do you start? Do you look at their current fundamental metrics, their latest earnings report, or how the share price has moved in the last couple of weeks in search of a good entry point? Recency bias arises when investors focus too much on the most recent events and price moments and not enough on all the other things a company’s market value is being derived from.

It’s easy to get caught up the hype while watching a stock’s price continuously go up in value, but remember that no stock can keep up huge growth rates forever. Eventually they will revert to their long-term historical averages, and you may end up just buying at the stock’s highs.

— REPRESENTATIVENESS BIAS —

You can’t fit a square into a circle.

Since we’re forced to consume and process so much information every day, it’s only natural to take some shortcuts. Our tendency is to try and categorize new pieces of information based on some sort of best fit approach; that is, assign it certain characteristics of other pieces of information we have already classified to make it easier to process. But sometimes our brains make mistakes, and sometimes we try and make things fit into existing categories when in reality, we probably should create a brand new category on its own.

Take Initial Public Offerings (IPOs) for example. Often times they are for products or services in entirely new industries, so you can’t really categorize them properly. Yet we do, based on things such as valuation ratios, expected growth rates of other recent IPOs, and other inappropriate measures.

— SELF ATTRIBUTION BIAS —

It’s never my fault. Unless I’m right.

If you’ve ever come across someone who is constantly attributing his/her successes to their own personal traits while blaming outside, uncontrollable factors for their failures, you can be sure they are exhibiting self attribution bias. For example, an investor may pat himself on the back if his stock pick is a success, but if it’s a failure he may blame the economy or maybe even other investors who “incorrectly” interpreted the company’s latest earnings reports.

As an investor, you must be cognizant of all the factors that go into a company’s valuation. Understand that your investment is risky and not a sure thing, and if it doesn’t work out then that may mean you simply did not take into proper consideration all of those factors.

— SELF control BIAS —

We tend to consume today instead of save for tomorrow.

Have you ever thought about why taxes are deducted from your pay cheque every two weeks but you only file your taxes once per year? Payroll departments are required to withhold estimated based on your earnings and only give you the leftover net pay, and any difference in estimates is resolved at tax time. And for many people, it’s a good thing it’s done this way because of self control bias.

Self control bias is when we would rather consume today rather than save for tomorrow. If given the choice, a rational person would prefer to receive gross pay and invest the taxes owing in some sort of high-interest savings account or GIC. But most people don’t go that route, as it’s too hard to resist spending that extra money today.