I hate to break it to you, but you're not built to be a great investor. I, for that matter, am not built to be a great investor. We're just not.
Over millennia our minds have been forged to deal with issues like figuring out whether the rustle in the brush is the wind or a tiger that's about to eat us. It's been burned into our psyches that we'll survive better as part of a group than on our own. For some odd reason, though, Mother Nature hasn't optimally equipped us to beat the S&P 500 index.
Beating the biases
Earlier this month, author and journalist Jonah Lehrer was on The Motley Fool Money Radio Show (you can download past episodes by subscribing on iTunes) talking about how we can make better decisions. How does this apply to investors in particular? I took away two very important points from what he had to say:
- Knowing is half the battle. G.I. Joe nailed this one. As Lehrer put it: "The only way to avoid these flaws is to know about them." It's impossible to spot biases in your thinking if you don't even know what they are.
- You're not different. Cognitive biases aren't something confined to your neighbor or the guy on the other side of the trade you're making. You're going to fall victim to them, too, so feel free to refer back to point No. 1.
The laundry list
Following Jonah's advice, I've dug through a bunch of the research on cognitive biases and picked out some of the main offenders that investors need to be concerned with. There are an impressive number of biases, so this doesn't cover them all, but if you learn how to spot these, you'll likely be ahead of the game.
1. Representativeness heuristic. You fall victim to this when you draw a conclusion about something because it resembles something else. Somebody calling a tech stock "The next Google (Nasdaq: GOOG ) " is likely falling victim to this. The company may resemble Google in some fashion, but the probability of a company being as successful as Google is phenomenally low.
2. Regret aversion. When you look back at an investment in hindsight you don't want to feel stupid for making the investment. This might push an investor to invest in a company like Apple (Nasdaq: AAPL ) -- which is large, well-known, very successful, and has plenty of positive coverage -- rather than a lesser-known company that may have a lower valuation and more growth opportunity.
3. Confirmation bias. We tend to seek out information that confirms beliefs we already have. So a Netflix (Nasdaq: NFLX ) investor, for instance, may focus on the growth potential from more consumers ditching cable, the company's content development efforts, and the addition of new content like Mad Men, while conveniently passing over concerns about the stock's valuation, higher costs to obtain content, and the potential for competition from the likes of Google, Apple, and Amazon.com (Nasdaq: AMZN ) .
4. Herd instinct. It may work well when you're dealing with a hungry lion, but it's usually much less helpful when it comes to investing. Just think Internet stocks in 2000 or housing stocks in 2006. If everyone else jumped off a bridge, would you do it, too?
5. Mere exposure effect. We tend to like things that we are familiar with. I found this out the hard way when listening to the radio too much led to me humming a Britney Spears song in the shower. For investors, this could cause us to like Apple, Google, or Amazon -- all of which have plentiful Wall Street analyst and media coverage -- more than National Presto Industries (NYSE: NPK ) -- which few investors have heard of and has one analyst covering it -- simply because we're more familiar with the former trio. But with room to grow and a forward price-to-earnings ratio of just 10.5, National Presto could be a better stock than the larger, better-known three above.
6. Outcome bias. This occurs when we evaluate the wisdom of an investment based on the end result. In fact, any investment with any probability of a positive outcome can turn out well, but the advisability of the investment depends on the probability of the positive outcome and the expected payoff. Judging an investment on the outcome can lead to getting lucky on a bad investment decision and using that as the basis to repeat that bad decision.
7) Post-purchase rationalization. When we own something, it tends to suddenly become more valuable in our eyes. The investing connection here is that you may have done sober analysis prior to buying a stock, but once you own it you need to be even more careful that you're not putting on the rose-colored glasses when evaluating it.
8) Overconfidence. This one speaks for itself to some extent. Things that we express the most certainty about rarely have the high degree of probability that we attribute to them. Maybe, just maybe, there was a little bit of this going on with bankers' models in the lead-up to the financial crisis.
9. Ostrich effect. According to a recent Pew survey, only 47% of homeowners think that their home has lost value since the start of the recession. Sometimes it's just easier to ignore reality than face up to what it means. The signs of a company in decline are often there before the worst of the stock's losses, but we have to be willing to see and accept them.
10. Clustering illusion. We tend to be suckers for patterns. We love them. Even when they're not actually there. This bias is exactly that -- seeing patterns where none actually exist -- and is the basis for commentary like this on silver stock Silver Wheaton (NYSE: SLW ) :
Note the twin double-top breakouts -- the first in February and the second last week -- which are very strong technical signals. ... Initial support rests at just over $42, which is the stock's intermediate support line. Buy at market and add to the position down to its intermediate support line.
Many traders like to tell stories based on the squiggles that a stock makes over time. The technique is particularly tempting because of our natural love of patterns and the fact that it reduces the need to read SEC filings to zero. But in making investing decisions, sober fundamental analysis -- for Silver Wheaton or any other stock -- is your better bet.
Motley Fool co-founder Tom Gardner isn't putting his head in the sand when it comes to his worst watchlist stocks -- he's put them right out on display.