We're All Biased. Don't Let it Impact Performance

We all make judgments, big and small, on a constant basis: 

I'm pretty sure my car can fit in that space. $40 should be more than enough to spend on a gift for my nephew. Acid rock has no musical value. Neither of these presidential candidates is truly fit for 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 consideration where appropriate. That we've assessed the available data and decided using 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 heavily publicized recent shark encounters around Cape Cod 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.

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. Perhaps, in fact, it will return to and rise even higher than your purchase price. However, converting what is currently a "paper loss"— 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: Under Armour 2017-present.)

Getting around loss-aversion bias is tricky. Typically we must first disassociate our emotions from our stock holdings, not easy. (Do you own Microsoft? Netflix? Have you held them a few of years? Do you love them? There you go.) 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? 
• Does it still have a strong competitive position? 
• Products solid, customer loyalty strong, management seems to know what it's doing? 
• Inventory levels look historically average? 
• Does the business still have more than enough cash for operations? 

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 ignoring important material events, such as the rise of a worthy competitor, the deterioration of the business's product pipeline, or a degrading of the company's executive decision-making. Or the business makes a sizable acquisition in a seemingly-unrelated field (why did AMC theaters buy a gold mine??). All these should be cause for concern.

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 do an 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 ... (Zoom Video, a pandemic staple, just can't get its act together.)

Overconfidence Bias, just as it sounds, is the misperception 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 philosophy T.A. in college does not generally indicate you will be able to competently replace your own iPhone screen.) Do you know someone who felt super smart about their getting in on the run-up in GameStop or AMC stock during Covid? How do they feel about it now? 

The only way to overcome overconfidence bias is by questioning yourself and your data on a constant basis. Also, getting your butt handed to you a few times will also get the job done. Nothing to be ashamed of: no one who's been stock investing long enough can honestly say they've been burned from sheer hubris.

Action Bias is the most troublesome of all. Put simply, action bias is the tendency— the need— to do something, really anything, to fix your portfolio and goose your returns. But nearly always the most appropriate response, when earnings are reported or when news comes in, is to do nothing. No doubt you know all about this: ever thought about getting off a clogged freeway in favor of surface streets? Probably won't save you time, but at least you'll be moving, right?

Action bias gets everyone eventually. Russia is making gains in Ukraine, China's economy is sliding, Apple is being by the US Justice Dept, the election will disrupt the market ... Time to sell everything and cash in before it all goes to hell? No, time to sit on your hands. Or, Nvidia just keeps climbing, so obviously it's overvalued and we should sell and take the profits, right? Wrong, looks like the business is cheaper now (based on revenues and profits) than a year ago.

About 95% 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 these stocks. You say you're in for the long haul, meaning 5-10 years or even more— this is your first home, or your kids' college tuition, or retirement funding. As a rule, don't make long term decisions on short-term news. If you are indeed doing careful analysis at the beginning, then once you own the company you must trust the managers that work for you, and trust your own earlier 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, make your play, pay attention, guard against your own biases. Then do it again. And again. You'll do fine.