A silver lining of the kind of market volatility we've experienced thus far in 2022 is that it can serve as a sobering reminder to revisit your thesis on each position you own and reevaluate your portfolio to withstand the turbulence. Periodically reviewing your holdings is crucial to keeping your investment goals on track and allowing for reflection on whether your investment thesis still holds true for each position in your portfolio. Since the pandemic began, speculative trading has become more prevalent with the trend of trading meme stocks, and potentially falling victim to certain behavioral biases.
The author, professor, and Wall Street strategist Michael Mauboussin has theorized that there are four types of "edges" in investing:
Given their size and scope, as a general group, professional investors have advantages over individual investors when it comes to the Analytical, Informational, and Technical edges—they have the capital, the infrastructure, and the personnel to exploit these zones.
But professionals don't necessarily have any advantage in the Behavioral zone—we are all humans, after all. The average person makes 35,000 decisions in a single day—and in this day and age investors, even professionals, are constantly inundated with new information, making it is easier than ever to succumb to biases without realizing it. However, if you are aware of these potential biases, you can adapt your investment approach to mitigate or even eliminate their effects.
"Behavioral finance," the study of how psychology affects markets and market participants, has become increasingly studied in recent years. I am fascinated by the topic, and the ways in which our psychology can undermine our best-laid plans, and so today I want to present a chart of select, common (and potentially costly) behavioral biases, a description of each, and, most importantly, how you might be able to mitigate them in practice.
|
Name |
Description |
Mitigation |
Anchoring and Adjustment Bias |
An investor selects an arbitrary number as a starting point and ‘anchors’ around this number even when new information is presented. The new information is taken into consideration with the initial figure in mind and not properly adjusted. |
Take plenty of notes during your research so you have an accurate basis for conclusions and your investment thesis. |
Confirmation Bias |
Information is sought out to confirm current belief and new, contrary information is discounted or ignored. |
During your research, find several articles/opinions that present a contrary point of view to your belief. Be able to provide at least 2–3 valid points for the opposition to see if your thesis still holds. |
Endowment Bias |
An asset is felt to have added value or be more special because it is already owned, such as an inherited stock. |
Perform market research on the fair value of the asset to ensure you are not inflating the value due to an emotion attachment. For assets such as a house or collectible, have an independent appraisal for the true fair value rather than relying on your own assessment. |
Framing Bias |
Occurs when an investor makes decisions based on the way the information is presented (framed). The way a question is presented affects the answer, usually in reference to gains/losses. |
Complete a risk tolerance questionnaire to understand how you view risk/rewards based on different types of questions and how they are posed. You may realize you view risk differently when posed as an emotional feeling vs. a statistical figure. |
Loss Aversion Bias |
Losses hurt an investor more than a gain provides pleasure, leading an investor to hold losers too long. |
Create an asset allocation policy for your investment goals and stick to a rebalancing strategy so you have a plan in place for your portfolio. Also, setting up stop-loss orders can be one way to mitigate significant downside losses on a single position. |
Mental Accounting Bias |
An investor treats pools of money differently based on how he/she categorizes its purpose. |
Make asset allocation decisions based on your full portfolio as a whole, not as separate portfolios. When viewed as separate portfolios, there is potential for significant risk overlap causing you to be less diversified than viewing the portfolio in its entirety. |
Self-Control Bias |
An investor places greater emphasis on instant gratification vs. achieving long-term goals. |
Create an Investor Policy Statement (IPS) to outline your long-term investing goals and create an appropriate asset allocation strategy to achieve them. Having a plan in place will help control the urge to chase short-term gratification. |
We hope this serves as a good reminder that investing isn't all spreadsheets and numbers but a healthy dose of psychology. It is an art. And unfortunately, during volatile times the psychological aspect can be exacerbated leading to panicked, emotional trading—as Mike Tyson famously told a reporter before a heavyweight fight, "Everybody has a plan until they get punched in the mouth."
At 1623 Capital, we believe the best ways to mitigate these common biases are to constantly communicate as a team, seek contrary opinions, perform in-depth research, and focus on our long-term objectives.
— Mark Reagan, Senior Associate, 1623 Capital