Monday, August 17, 2015

Stock Investing: Your Biases Will Kill Your Returns

We all make judgments, big and small, on a constant basis: I'm pretty sure my car can fit in that space. $30 should be more than enough to spend on a gift for my nephew. Acid rock has no musical value. Not one of the political candidates in the race is worthy of public office.

All the time, every day, we have to gauge our options and make a choice. And we believe we are generally being rational, that we have given considered thought where appropriate. That we've assessed the available data and decided based upon sound, rational analysis.

But we haven't. More often than not, our emotions and our patterns are guiding those judgments from the shadows. This is as true in investing decisions as it is in ordering dinner. But for most of us it turns out to be much more expensive.

Recency Bias occurs when a memorable event in the immediate past colors thinking and decision-making: shark attacks have always been quite rare, but highly public recent shark encounters sway beach-goers to stay out of the water. For investors, a long bull market irrationally affects thinking about future market performance, making success seem inevitable. Or devastating losses after a market crash in the near past keep otherwise sensible investors from buying in.

To ensure you are not falling victim to recency bias, look further back than your own experience. Investigate a stock's history going back 5, 10, 20 years. Look at its industry and even the broader market over a longer span. In the longer view, any recent event seems relatively insignificant.

SodaStream's failed campaign, SuperBowl 2014
Loss-Aversion Bias is the idea that a stock in your portfolio which has declined since purchase should not be sold, because it "will come back up." Perhaps it will, in fact, return to and above your purchase price. However, converting what is currently a "paper loss"-- as the lost value exists only on your brokerage statement-- to a real loss by selling the stock at a lower price is fundamentally repellant; the human psyche often rejects as impossible those things which appear uncomfortable or painful, or dangerous. (see: Sodastream 2014-2015. Ugh.)

Getting around loss-aversion bias is a less obvious path. Typically we have to first disassociate our emotions from our stock holdings, no easy trick. (Do you own Apple? Netflix? Have you held them a couple of years? Do you love them? Then you take my meaning.) If you are successful in divorcing emotion, you need to get into the reeds on that devalued stock you own: are all the reasons you bought it still true? Products solid, consumer perception on good footing, management seems to know what it's doing and communicates that to shareholders? Does it still have a strong competitive position? Does it still have cash? If these are all true, then perhaps you are correct, and the stock will rebound and maybe you should pick up some more of it. If not, however, you'll need to do some more digging: the market clearly disagrees with your assessment.

Confirmation Bias is very common but virtually impossible to self-detect. It is the tendency to subconsciously run incoming information through a preexisting preference filter, such that we confirm what agrees with our beliefs and reject what does not. This can lead to the rejection of material events, such as the deterioration of a company's product pipeline or their executive decision-making. Or defending a sizable new acquisition in a seemingly-unrelated field, or taking on substantial debt when previously the company was self-sustaining.

3D Systems' magnificent, colossally unpopular 3D printer
This is not to say that no corporation can adjust to or recover from such events, as these things occur all the time even in very strong companies with fast-rising stocks. However, to counteract confirmation bias we must undertake objective, detached examination of any developments which materially affect stock value. Sometimes a down stock doesn't come back up, it just goes down, and down ... (see: 3D Systems. Ahem.)

Overconfidence Bias is, just as it sounds, the idea that we have an edge where others do not. It stems from success, sometimes from success in completely unrelated areas. (The fact that you were a 300-level astrophysics T.A. in in college does not make you a better stockpicker.) Did you or someone you know feel really smart about their big tech stock bets at the end of 1999? Do you remember how smart they felt in summer 2000? 

The only way to overcome overconfidence is by questioning yourself and your data on a constant basis. Though getting crushed a few times will also get the job done. Few who've been stock investing long term can honestly say they've never burned themselves from sheer hubris.

Action Bias is my personal favorite. Put simply, action bias is the tendency to do something, really anything, when the most appropriate response is to do nothing. No doubt you know all about this: ever thought about getting off a clogged freeway in favor of surface streets which you suspect will be no faster-- but at least you'll be moving, right?

Action bias gets everyone at one time or another. China's economy is slipping, ISIL took another city, Greece will default, the Fed will raise rates: Time to cash in and get out of the market before it all goes to hell? Disney stock falls hard on quarterly earnings news: Sell it? Buy some more?

About 80% of the time, the correct reaction in these moments is to do nothing at all. You did your research early on, before you bought each of your companies' stocks. You say you're in for the long haul, meaning 5-10 years or even more-- this is the kids' college tuition, or retirement funding. As a rule, never make long term decisions on short-term news. Do you think Greek debt will still be in the daily news 5 years from now? Will China's economy still be a shambles? You chose Disney, a quality company; will it have righted itself in 10 years time? If you are indeed doing careful analysis at the beginning, then once you own the company (that's what it is, after all) you must trust the managers that work for you, and trust your own (previous) judgment.

And really, it's all judgment. Stock picking and stock investing is more art than science, no matter what you read about uptick volumes and Fibonacci retracement and resistance levels. No one knows what an individual stock is going to do, never mind the entire market. So do your homework, place your bet, pay attention, guard against your own bias. And you'll do fine.

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