Were you ever punished in school for not behaving properly in the class?
If you are like me, you must have experienced the happiness (mixed with some embarrassment) of being an ‘out-standing’ student on a regular basis! But then, you must have behaved well after that punishment.
Sometimes I wonder if we as adults were always guided and punished by our teachers for all our mistakes and mindless behaviour. Growing up and moving out of school gives us a lot of freedom to behave the way we want to. But then, for some of us, it becomes a license to behave any which way…even at the cost of our own peace, and money.
Talking about stock markets, the pundits will tell you that to learn to invest, you need to read the theory books. You need to understand complex accounting. You need to know the jargons, the P/E, the EV/EBDITA, the SOTP.
What these pundits however fail to tell you is that before you get to all that investing theory, you need to work on the practical. You need to study ‘yourself’…your behaviour.
We are who we are…
…but our behaviour shapes us. And as human research suggests, 70% of our behaviour is shaped by our experiences (the remaining 30% by our genes).
This implies that whatever we have learnt about saving and investing from our parents doesn’t matter that much. What matters is what we have experienced ourselves in our lives and professions.
The brain is a leaking boat
We call ourselves rational beings. The truth is that we aren’t rational but rationalising beings.
The brain that sits on the top of our head isn’t a flawless machine. Yes, it is powerful. But it has its weaknesses. In everyday terms, we call such weaknesses as ‘biases’.
The good part is that while we cannot exchange our brains with other people nor can we upgrade it at a hardware shop, we can avoid mistakes that our biases cause by just taking notice of them.
It’s just like getting into a boat. Before getting in, you would want to know about any holes in it before you start paddling. Right?
Biases are such holes in our brain’s reasoning abilities. And these biases can damage our decision making.
Here are five most common biases that we carry with us, and which can really have a negative impact on our decision making capabilities, including the way we invest in stocks.
Answer this simple question – “Which is the world’s only officially Hindu country?” India? Sure? Confident? Over-confident? Sorry, but you are wrong! It’s Nepal.
Now tell me – “Are you sure the stock you just bought will go up?” See, you are again getting over-confident!
2. Confirmation bias
You can call it ‘wishful thinking’. Confirmation bias appears when you see what you want to see. It’s a bias that makes you notice and look for information that confirms your existing beliefs, whilst ignoring anything that contradicts those beliefs.
3. Availability bias
More people are killed every year from attacks by donkeys and by drowning in swimming pools than those who die in car accidents or plane crashes! But just after a plane crash, we give more prominence to those killers than anything else. So what is the reason for that? The answer lies in ‘availability bias’, which is a phenomenon in which people predict the frequency of an event based on how easily an example can be brought to mind.
You may think it’s fine to eat a burger that is 90% fat-free. But when you turn it around and think of it as a burger that’s 10% fat, you may think twice about eating it. That’s what ‘framing’ does to you – how you say and hear things makes a good impact on how you respond or act. In investing, a 50% loss hurts more than the pleasure from a 50% gain.
When in doubt, follow! This is what the herding bias tells us. We are programmed to feel that the consensus view must be the correct one. This mistaken belief that ‘not everyone can be wrong’ has led to many a disastrous decision. The Great Depression of 1920-30s, the dotcom boom of 1999-2000, and the more recent financial crisis are the most famous examples of how investors have lost big time by doing what everyone else was doing.
So, which herd are you following?
Know the holes, and fill them
Simply noticing the holes in a boat won’t save you from drowning. A boat will fill with water whether you are aware of a hole or not. But by being aware of the holes you can devise methods to patch them up.
In the same way, if you know how your biases can hurt you, you will take precautionary action to safeguard yourself from them.
So just be aware of yourself…and mind your behaviour.
P.S.: This is the eleventh lesson of the 20-lesson free email course on the essential pillars of becoming a successful investor, Safal Niveshak-style. We talk about simple investing strategies that will work for you, and make you a smarter and successful investor. Learn more about the course or simply sign up here.
Found these videos on youtube. Nice illustration of Availability Bias and Herding
Disclaimer : These videos have been created by Templeton India Investments for promotion of their fund management services, so you may want to ignore the promotional part in the videos.