We’re all subject to investment biases, often multiple biases working simultaneously, trying subconsciously to derail us. Whether we offload the actual order execution and management to an auto-trading platform or not, the human element of investing still impacts the decisions we make and the strategies we choose to execute or not. Until we take the time to label and recognize these significant investor biases, we cannot overcome or manage them in the future. Today’s podcast is geared specifically at exposing these classic and detrimental investor biases that ruin performance. You’re either going to learn how to manage and deal with these investor biases or be unknowingly controlled by them for the rest of your life.
Two Things to Focus on Before Going Through The List:
- We cannot recognize the difference between a positive and a negative experience when we’re in the moment. Situations that feel negative often turn out to have positive effects. We can use our knowledge of this fact to rise above situations that feel negative at the time.
- We have to be aware of false positives and false negatives. Strategically wrong decisions based on biases that turn out well due to luck are not reasons to make the same choices in the future.
13 Investor Biases in No Particular Order
1. Loss aversion
- People often feel the pain of loss more than the joy of gains. This leads to behavior where people try to avoid losses because of their pain and make decisions that can make the loss even worse. Losses need to be taken as part of the game of trading.
2. Confirmation bias
- People are often drawn to information or ideas that validate existing beliefs and opinions. For example, many TV viewers prefer a news channel representing their own political views, avoiding those featuring commentators of different views. If you start with the idea that hyperinflation is imminent, you will probably read lots of literature by those who share the same view. When everything confirms your opinion, you’re missing something. Look for the counter-argument. Understand both sides clearly.
- With trading, it’s better to trade based on market indicators rather than biases. Auto trading can be helpful here because if you are making trades yourself every day, one news story could derail your strategy if it appeals to your confirmation bias.
3. Hindsight bias
- This is the “I knew that would happen” mentality. You think something might happen in the stock market, and then it does. Because of this, you overestimate the accuracy of your future predictions. This can be costly as we get a false sense of security when making investment decisions, leading to excessive risk-taking behavior, and placing portfolios at greater risk. Just because something went one way a few times doesn’t mean it will continue to do so in the future. Only after the fact do all the puzzle pieces make sense.
4. Optimism bias
- Optimism bias, or the ‘hope slope,’ is when an investor makes decisions based on hoping that things will turn out OK, despite evidence to the contrary.
- For example, in the event of the poor performance of an investor’s holdings, they still grasp at or clings on to any news–albeit unreliable–to support their belief that there will be a recovery in the investment, choosing to hold onto their position rather than close it out. Don’t ignore reality in an attempt to rationalize a particular viewpoint.
- If you get to a point where the stock or position is losing, just close the position instead of increasing the position size or making the spread wider due to optimism bias.
5. Mental accounting
- First identified by behavioral economist Richard Thaler of the University of Chicago, mental accounting occurs when a person views various sources of money as different from others. Mental accounting can manifest itself in many ways. For example, money earned at a job may be viewed differently than money from an inheritance. This can affect the way the money is spent or invested.
- If you get a gift card for your birthday, why squander the money on it? Treat it with the same care as if it was money from your bank account. Don’t open a brokerage account for fun. If you open a brokerage account and you start trading, that should be a serious endeavor.
6. Illusion of control
- This refers to thinking that your decisions and skill led to the desired outcome when luck was likely a significant factor. Smart people try to predict the market, and sometimes a prediction ends up coming true due to chance, which then gives them the illusion that their intelligence or education gives them a leg up for predicting the market. People who live under this belief have trouble coming to terms with the irrationality and variability of markets and the impossibility of predicting them.
- The beautiful thing about trading is that the things we actually have control over tend to be the things that matter the most. We do not have control over what the president tweeted, but it doesn’t matter because we can control position size, what markets we trade, what strategies we use, and how we allocate our capital, which are the things that we need to control anyway.
7. Recency bias
- Recent information is fresh and attractive and, therefore, is incorrectly perceived to carry more weight. Letting recent events skew your perception of the future, thinking that what has happened recently will continue to happen, is the result of recency bias. The phenomenon often exists in investing where retail investors tend to chase investment performance, piling into an asset class just because the investment has been climbing higher recently. This often happens as it is peaking and about to reverse lower – think of what happened recently with Tesla.
8. Anchoring bias
- What happens in anchoring bias is that your investment decisions are anchored around the first piece or pieces of information you receive. Investors anchor to the idea that a fair price for a stock must be more than they paid for it, and trade based on that belief, rather than readjusting their opinion based on new information
- For example, you buy a stock at $50, the stock continues to go down, but you hold on to this anchoring bias that $50 is a fair price. Maybe new information comes out – the company’s not expanding or had some issue, or some sector is starting to rotate over. However, you still hold on to this $50 price that you paid for the stock, instead of allowing the new information to shift how you trade and how you invest based on new data.
9. Endowment effect
- When evaluating an investment, investors place a higher value on an investment they already hold than they would if they did not own the asset and had the potential to acquire it. As a result, investors place an irrational premium in the desired selling price of an asset.
- This can be tested out. Try getting rid of clothes or stuff in your house. You might not want to get rid of certain things because of perceived value, but would you buy those same items now if you saw them in the shops?
10. Framing bias
- This refers to reacting differently to the same information depending on how it’s presented. When presented with two headlines, i.e., “The market surged to the highest level in 5 years,” and, “The market hasn’t made significant gains in the last 5 years,” both could be true, but each framing could cause you to perceive same data differently, and thus make different investment decisions depending on which one you go with.
- This can be overcome by trying to see the other side of a potentially biased framing of something.
11. Skill bias
- This is when education and training cause confidence to increase faster than ability. The best example is the hedge fund Long Term Capital Management. Staffed thick with PhDs and two Nobel laureates, the fund exploded in 1998 under an incredible amount of leverage. Behind the failure was raging overconfidence. “The young geniuses from academia felt they could do no wrong,” Roger Lowenstein wrote in the book When Genius Failed. Warren Buffett said this about the firm’s sixteen-person management team: They probably have as high an average IQ as any sixteen people working together in one business in the country … just an incredible amount of intellect in that group. Now you combine that with the fact that those sixteen had extensive experience in the field they were operating in – in aggregate, the sixteen probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor, that most of them had virtually all of their very substantial net worths in the business, but essentially, they went broke.
- It is important to realize that if you have a high pedigree of education, that does not translate into taking bigger risks or proof that your investment strategies will do well, so you shouldn’t let your experience give you confidence that blurs your decision making. Investing is like a boxing match, and you need to learn to take punches and, most importantly, never get in a position where you take the knockout punch like the team at Long Term Capital Management.
- The plus side of this is that the playing field is level, meaning a new investor with little education can trade and still do well if they follow a sound strategy.
12. Escalation bias
- This is the classic “throwing good money after bad,” where you double down on a plunging stock, not because you believe in its future, but because you feel the need to make back losses. You double down on a losing position with the knowledge that a small move in the opposite direction gets you back to square one. This is a bad mentality because it can end in huge losses and disaster if the position does not change direction.
13. Herd/bandwagon mentality
- Investors that buy when the market is high and sell when the market is down are more than likely influenced by the herd mentality. This bias occurs when individuals are influenced by their peers to follow trends, purchase items, and adopt certain behaviors, even if it is not in their best interest. It is important to stop and ask yourself why you are making a financial decision and see if it aligns with your financial plan. Doing so will go a long way in ensuring that the actions you are taking are actually right for you, not for someone else. Something is not necessarily right because everyone says it is.
Option Trader Q&A w/ Michael
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Michael:
Hi, Kirk. Michael from Illinois. I was just wondering how interest rate hikes from the Fed should affect our options trading. That’s it. Simple question. Thanks for helping me out.
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
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About The Author
Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he’s a Full-time Options Trader and Real Estate Investor.
He’s been interviewed on dozens of investing websites/podcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.