One of the most important, yet overlooked attribute, psychology plays a critical role in an individual’s investing career.
Let us all agree to one thing, we all are humans and humans cannot live without exhibiting emotions. We are not saying that you have to completely eliminate emotions while investing which is not possible, after all its our hard earned money at work. We do say that we need to be AWARE of different kinds of emotions we experience during the course of investing (which stem into biases) and this awareness would at the very least help us avoiding such biases consciously. Starting off..
BEHAVIOURAL BIASES FACED BY AN INVESTOR
Analysts are generally prone to the below mentioned two broad behavioral biases which can significantly distort decision-making and thinking of the person:
OVERCONFIDENCE: Analysts can be susceptible to overconfidence as a result of undue faith in their own forecasting abilities caused by inflated opinion of their own knowledge, ability, access to information and processing of that information. They tend to remember their previous estimates as being more accurate than they really were. As a result, they overestimate their accuracy and underestimate potential risks.
Many other biases contribute to the overconfidence in the analyst. For example, ‘illusion of knowledge’ bias in which they think they are smarter than they really are. This is fuelled when they collect large amounts of data which leads them to think they can make more informed decisions as they have more information than others. They exhibit ‘representativeness’ in which an analyst judges the probability of a forecast being correct based on how well the available data fits the outcome. They also exhibit ‘availability’ bias when they give undue and excessive weights to recent and readily recalled events. Being able to quickly recall information makes the analyst more likely to ‘fit’ it with new information and conclusions.
To subconsciously protect their overconfidence, analysts utilise ego defense mechanisms. One such mechanism is the ‘self-attribution’ bias. Analysts take credit of their successes and blame others or external events for their failures. They subconsciously avoid to admit mistakes and justify it with some reason to make them feel good about their capabilities. Another ego defense mechanism is the ‘hindsight bias’ where the analyst selectively recalls details of the forecast or reshapes it in such a way that it fits the outcome. In this way, although the forecast was off the target, serves to fuel the analyst’s overconfidence.
To overcome these biases, particularly overconfidence bias, analyst should practice ‘self-calibration’ which is the process of remembering their previous forecasts more accurately I relation to how close the forecast was to the actual outcome. Documenting the reasons behind decisions at the time of decision-making allows for an objective assessment at a later date. Analyst should also seek counterarguments against his opinions, supported by evidence, for why their forecasts may not be accurate. Analyst should carefully review their gains, asking whether they resulted from their decision-making or pure luck.
When reviewing successful and unsuccessful investments, analyst should look at systematic patterns in their decision-making. Acknowledge and write down all the mistakes done during the research process with an open mind. Only by this way, the analyst will be able to improve slowly and steadily.
BIAS IN RESEARCH: One bias is that the analyst collects so much information, important and non-important, that it leads to information overload and results in improper placing of weights. The other bias is confirmation bias which is the tendency to view the new information as confirmation of an original forecast. It makes analysts ignore contradictory information or interpreting information in such a way that it conforms to the analysts way of thinking. The analyst also suffers from one more bias, ‘the gambler’s fallacy’ where the analyst might think that there will be a reversal to the long-term mean more frequently than actually happens.
Therefore, to avoid bias in research, analyst must take certain preventive measures to ensure all these biases are in check. For example, analysts should be aware of the possibility of ‘anchoring and adjustment’ when they recalibrate forecasts given new information. They should take systematic approach with prepared questions and gather data before forming any opinions or making conclusions.
Analyst can also be influenced by the way company management presents information in their reports. Therefore, the analyst is susceptible of framing bias and anchoring and adjustment bias while reading the annual report. It is advised that the analyst should not focus on how the management frames and presents the information, rather focus on hard facts and their impact on the profitability of the business.
To conclude, more than trying to avoid biases like overconfidence which are fueled by illusion of knowledge and control, availability bias, representativeness bias etc. the analyst should more importantly be aware of all such biases which will affect his research and decision making process. In the end, these biases will not help the analyst achieve anything apart from losses. He should be aware how the human brain is wired to forcefully fit the information that is easily available and transform the meaning of that information in such a way that will conform to the original thoughts of the analyst.
The analyst should not try to form any preliminary impressions about the business he is researching. He should try not to comprehend the way the information is presented and rather focus on collecting all facts and figures necessary for decision-making and write them down in plain and a simple language free of any tone. He should try to practice Bayesian theorem which will help him calculate probabilities more accurately. Rather than relying on past knowledge, the analyst should try to start fresh from the beginning and look at all the facts with an open mind. After a decision has been made, the analyst should write down his thought process in detail in order to review the work later. After some point, the analyst should regularly revisit his previous research to see how his work actually fared up. Finally, self-improvement will begin when the analyst actually admits all the mistakes he made during the process and actually try to learn from it.
ALWAYS REMEMBER: In downward markets, a change for the company’s worse gets far more quickly accepted by the financial community than a betterment. Opposite is true for the rising markets.