Right now, as we speak, there are silent killers living in our brains, destroying our potential returns. No, it's not the plot to a sci-fi horror film. These sinister agents are decision-making biases, and they're 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 this interview, he tells us which ones to look out for, and he 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.
(NASDAQ:GOOG)new Checkout online payment system may be showing overconfidence in its confrontation with eBay's (NASDAQ:EBAY)PayPal.
Anchoring and adjusting: The homebuilding industry has seen plenty of ups and downs recently. When the market was booming, investors may have anchored on the rising prices on homebuilder stocks like Toll Brothers
(NYSE:TOL)and Centex (NYSE:CTX), bidding prices too high to match artificially inflated growth expectations. Those same investors may have anchored on the current falling prices of housing stocks, painting themselves too bleak a picture of those investments' prospects. Understanding anchoring and adjusting can not only protect us from the market's wild swings, but also point out potential buying opportunities.
Framing: According to J. Edward Russo and Paul Schoemaker in Winning Decisions, framing involves creating a mental structure that simplifies how we look at a complex situation, making us view problems from a particular, and limited, perspective.
The classic example deals with making choices between the same outcome, using positively and negatively worded frames. For example, if offered a choice between taking a life-saving drug that has a 20% chance of success, or one with an 80% chance of failure, most people choose the first option, even though both choices are the same. How the choice is framed affects the resulting 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 I began to question my judgment. Instead of dismissing the contradictory investing thesis out of hand, I sought to understand the bear case. That let me figure out how best to check whether my original idea still held up. So far, so good.
I've read much of Michael's work, and I had the privilege of speaking to him before this interview, so I'm familiar with the investment-journal antidote to biases. As my colleagues at Fool HQ can attest, I'm constantly scribbling investment ideas in my own notebook.
I did so while analyzing outdoor sporting-goods retailer Cabela's
Looking back at my journal, buying amid such anxiety was a mistake. I may not have known 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 interview and these 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 decisions in the future.
This article was originally published on July 11, 2006. The framing bias was changed to provide a clearer example.
Retail editor and Inside Value team member David Meier owns shares of Deckers and Cabela's, but does not own shares in any of the other companies mentioned. He is currently ranked 449 out of 21,138 investors in the Motley Fool CAPS stock-rating service. You can view his TMF profile here. Deckers Outdoor is a former Hidden Gems selection. The Fool takes its disclosure policy very seriously.