Right now, as we speak, there are silent killers living in our brains, reducing our potential returns. They affect each and every one of us. No one is immune.
No, it's not the plot to a sci-fi horror film. It's the decision-making biases that are chronically hurting your portfolio.
But have no fear. Help is on the way.
To learn which biases hurt investors the most, I asked Michael Mauboussin, chief investment strategist at Legg Mason and author of More Than You Know. In part 4 of our interview, he tells us which ones to look out for and offers some simple tips to combat them.
David Meier: What psychological bias trips investors up the most?
Michael Mauboussin: Well, there are a whole slew of these [biases], and I think it is hard to point to any one of them, but [there are] a few that I would mention. One is overconfidence. Overconfidence basically is that we tend to be overconfident in our own capabilities and assessments, not only in the world of investing but also outside the world of investing, so it is very important to try to calibrate yourself on that front.
Another one is anchoring and adjusting, which is when someone presents you with a piece of information, which may or may not be relevant to the decision that you are making. We often will anchor on that piece of information and adjust from there -- and often inappropriately adjust from there. Anchoring is a very, very powerful factor in markets and also outside of markets.
The third would be framing effects, which is where I can present you with the same mathematical situation, but I can present it in two different ways. I can frame the situation two different ways. How I frame it will affect how you choose, so making sure that you are describing problems well, that you are framing them properly, really walking around problems from 360 degrees, is extraordinarily important.
The last one is a consistency bias, which is once we have made a decision, we tend to seek confirming information and we push away our disavowed, disconfirming information. This is also a very profound mental mechanism that we all use.
David Meier: How can we prevent ourselves from making these mistakes?
Michael Mauboussin: Well, first of all, learn about them. So, some degree of self-awareness is the first path toward mitigating them.
The second thing is actually not too difficult to do, but very few people actually do it, and that is to keep an investment journal. Every time you make a decision about something -- investments in particular -- write down specifically what you are doing and why you are doing it. Also make note of your own mental state. I'm in a good mood today, the sun is shining, I'm in a bad mood, what have you. [Writing these things down] acts like a truth serum.
What we all tend to do, by the way, is something called hindsight bias. Once something has come to pass, we think we knew what was going on. The investment journal allows you to go back and review specifically what you were thinking at that time and, again, provide you with some sort of quality feedback. And, of course, being in your own hand, it is very difficult to deny.
Biases in action
Michael gave us a quick overview of the biases that can trip us up. Here are some examples of those biases in action.
- Overconfidence: In part 2 of our interview, I gave an example of overconfidence using Google's (Nasdaq: GOOG ) new Checkout online payment system going up against eBay's (Nasdaq: EBAY ) PayPal. Click here to see that example.
- Anchoring and adjusting: The homebuilding industry has seen plenty of ups and downs recently. As more and more information came out about growing new home sales and rising real estate prices combined with easy financing, I wonder whether investors anchored on the rising prices on homebuilder stocks like Toll Brothers (NYSE: TOL ) and Centex (NYSE: CTX ) used those to adjust their expectations, given the aforementioned trends, and bid prices up too high based on extrapolated high growth. I also wonder whether investors have anchored on the falling stock prices of those same companies and adjusted their expectations using the news that housing sales growth is slowing. Anchoring and adjusting can cause some pretty wild swings in prices. Thus, it's important to understand anchoring and adjusting to not only protect ourselves, but also to find opportunities.
- Framing: Framing is best explained using an example by Professor Hersh Shefrin in his book Beyond Greed and Fear. Professor Shefrin asks his MBA students to read the possibilities for two choices and select one from each.
1. A sure gain of $2,400.
2. A 25% chance to gain $10,000 and a 75% chance to gain nothing.
3. A sure loss of $7,500.
4. A 75% chance to lose $10,000 and a 25% chance to lose nothing.
Shefrin says about 50% of his students chose 1 and 4. Unfortunately, that is not the best decision, as the combination of 2 and 3 offers a higher expected value. So, how the question is framed affects the decision.
- Consistency: I recommended footwear maker Deckers Outdoor (Nasdaq: DECK ) to Motley Fool Hidden Gems subscribers in the September 2004. Since that time, its price has swung wildly, rising to about $49, falling to about $17, and settling today around $37. Obviously, I liked the company, its products, and its prospects. But as the price fell to $17, I have to admit that many a night I questioned my judgment. Are Uggs a fad? Can Teva survive the onslaught from new products from Merrell (parent company Wolverine Worldwide (NYSE: WWW ) ), Chaco, and Keen? I thought that short thesis was wrong, and I could have easily dismissed it. Instead, I sought to understand the bear case. That way, I could recheck my thesis and figure out what new data to collect to see if my thesis still held water. So far, so good.
I've read much of Michael's work and had the privilege of speaking to him before this interview. So, I am familiar with the investment journal antidote to biases. In fact, as my colleagues at Fool HQ can attest, I always have a notebook nearby and am constantly scribbling in it.
I did so while I was analyzing outdoor-sporting-goods retailer Cabela's (NYSE: CAB ) . Although I like the company, its approach to growth, and the value it creates, I should have paid more attention to my mood when buying. I was away on vacation when I saw the price drop to a level that gave me a decent margin of safety. Needless to say, I was anxious to get back home to make my purchase. Unfortunately, the stock was on the rise again, and I didn't want to miss out.
Looking back at my journal, I should not have bought when I was so anxious to do so. That was a mistake. Sure, I didn't know that the price would fall significantly further. But at the same time, my anxiousness caused me to chase a price rather than take advantage of a better opportunity.
The Foolish bottom line
I hope this excerpt, complete with examples, will encourage you to keep these silent killers in mind when you make future investment decisions. Recognizing them today will help you make better decision in the future.
eBay is a Motley Fool Stock Advisor recommendation, while Deckers Outdoor is a Motley Fool Hidden Gems recommendation. Take the newsletter that best fits your investing style for a 30-day free spin.