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When it comes to investing most of us like to think that we know what we are doing. We trust in our own experience and our cognitive power to lead us through the darkness and to the light of a good investment. That however is not always true; we all have a certain set of cognitive biases through which we view the world. They have a serious impact on how we act in all things in life, and investing is no exception.
The good news about these biases is that they can be counteracted by simple awareness. Let's talk about three investing errors that seem to be a matter of common sense and yet affect many investors.
The first big mistake people often make is called "anchoring." Jeff Vollmer of Hyde Park Wealth Management explains anchoring in the following terms: "When making decisions, investors rely too heavily on too little information. We react to non-supportive evidence by further strengthening our current positions and beliefs"
Do you think you've never fallen prey to this type of information bias? Well, you may feel differently soon. Here is an example of how a too-narrow focus on information can impact your investing decisions, courtesy of Bob Williams, senior vice president and managing director at Delta Trust Investments:
In my opinion, the mistake that many make is relying on absolute numbers like earnings as opposed to relative or anticipated figures. Simply put, if a company reports earnings of $20/share, it sounds great but if the analysts have projected earnings of $40/share, the company under performed and the stock will likely fall. The absolute number sounds good but it is a bad number relative to expectations. Stock prices generally react more to relative than actual figures.
Anyone who got burned by Madoff can tell you that trusting a single source of investment advice blindly, no matter how good it may look, is a dangerous game.
Have you ever wondered why political news is so segmented? If you've noticed that there seem to be certain news stations for conservatives and others for liberals, then you have noticed a conformation bias. We tend to notice, and put more credence in, information that supports our point of view.
This bias not only prompts us to seek out information that confirms our point of view, but it also causes us to interpret information in a way that is consistent with our current beliefs. So if you think a company is rock-solid, you are more likely to hold on to its stocks even as evidence piles up that it's a poor investment. It takes a great deal of information to help us overcome a conformation bias.
If you bought stock in Apple (NASDAQ: AAPL ) last year at the advice of many industry experts, only to be be burned by the serious drop the stock took last November, then you got caught by a bias error. A number of experts were telling everyone to buy as Apple was getting ready to make a big announcement. When the announcement was for the iPad mini, instead of the newest revolution in mobile devices, the shares took a dive. If you listened to the majority of experts, instead of the small group rating it as a sell, you may have been the victim of your own confirmation bias.
So maybe you should have listened to Trip Chowdhry of Global Equities Research when he suggested that the event wouldn't garner the usual amount of public interest.
The company has bounced back, for the time being, but it has a high hill to climb if it wants to stay in that position. The newest iPhone has not garnered the same big opening day that previous versions of the phone have. Even the tantalizing prospect of biometric security and a candy-coated, lower-priced version (the iPhone 5c) have not been enough to bring in larger sales for the new product. After the lackluster response to the iPad Mini, the company was in need of a big hit. The newest version of the iOS has even met some serious backlash, meaning that users may switch to other platforms. New research is suggesting that lacking any major "wow" features. more users are holding on to their current phones for longer.
So take future suggestions to buy into the company with a grain of salt and look at how the mobile market on the whole is changing. Try to anticipate consumer behaviors before you get hyped up about a new announcement. They just don't seem to whip consumers into the same frenzy they used to.
Have you ever blown off good advice because of where it came from? Then you have fallen victim to a cognitive bias known as framing. Vollmer explains framing thus: "We draw different conclusions from the same information, depending upon how or by whom the information is presented." So if information comes from an unusual place, you may be likely to skip it and go with sources that have proven themselves in the past, no matter how inaccurate their information may seem.
When James Glassman suggested last year that you buy stock in Ruby Tuesday (NYSE: RT ) before it made a serious uptick that spring, if you ignored him because of his associations with a U.S. president who was unpopular in a certain political set, then you missed out because of a framing issue.
The folks over at that company have a stunningly sharp eye on their consumers. Ruby Tuesday was one of the first chains to attach itself to the fast-casual trend, which bridged the gap between a sophisticated atmosphere with good food that comes out in a timely manner -- a sweet spot that some chains still struggle to get into. Other decisions, like an upscale makeover as the economy tanked, have also made the chain a standout from competitors in its price range. The company's approach of going against the tide is likely to suit it well, provided it can keep its price point in line with the less sophisticated options.
Now that you know about these biases, you can watch for them in your thinking. You probably won't catch yourself 100% of the time, but you can improve your investments by being more aware of your own biases.