Making mistakes is part of investing, but there's no better way to improve your investing skills than to overcome your built-in biases. As human beings, we need to train our brains to be Foolish. To that end, I'll describe some common biases investors struggle with, and how we can defeat them.
We're overconfident
One of the biggest biases we face is that the more we learn, the more confident we get. To illustrate with an example from John Mauldin's Just One Thing, Paul Slovic did a very interesting study with horse-racing bookmakers. He came up with a list of 88 variables relating to a horse's performance and data for the 40 past races, which he then gave to the betting professionals. Each professional was asked to rank the 88 pieces of information by importance. Slovic then asked the bookmakers to rank the top five horses for each race, using the top five variables by importance, and then the top 10, 20, and 40 variables.
The result: The accuracy of the picks remained the same, no matter how much information the bookmaker had. However, the bookmakers' level of confidence that they were right roughly doubled as the amount of information increased.
As investors, we face a similar dilemma as we sort through mounds of information in our attempts to discern the truth regarding a given company. Knowing the most about a company doesn't always make our judgment of that company correct.
To make the most accurate predictions possible, we've got to understand which factors are most significant in evaluating a company. Here are a few of the metrics I look for:
- Dividend policy (management rarely changes dividends lightly)
- Cash flow trends
- Net margin trends over time
- Management compensation
- Competitive positioning and advantage
However, in researching these factors, we must also learn to set aside the information that isn't significant.
We emphasize the unimportant
The second bias that we face is our tendency to place too much emphasis on unimportant bits of information about a company. Most of the everyday news about our companies has little to do with their long-term prospects and shouldn't matter to Foolish investors. Selling a company based on weak short-term performance while ignoring upcoming products that might have huge benefits to its future sales can be as bad a decision as buying the wrong stock altogether. Some Fools review their stocks only once a quarter, to avoid the temptation of making decisions based on near-insignificant details discovered after hours of reading SEC filings on a Friday night. (What? You don't do this on Friday nights?)
The numbers Wall Street tends to focus on rarely make a difference in a stock's long-term success or failure. Does it really matter if a company reports 15% growth instead of 16% growth, or beats or misses analysts' earnings estimates by a penny? Unless these events portend a shift in long-term operational trends, they shouldn't even register on a Foolish investor's radar screen -- much less be considered a reason to sell.
We cling to preconceived notions
A third bias is "confirmatory bias" -- our tendency look for information that confirms our opinion about something, rather than information that runs against the grain. Investors researching a company whose practices or products they like and respect are often prejudiced in the company's favor. An investor in that situation would be more likely to look for positive information to confirm that he or she is right, ignoring more negative information about the company. Sometimes, investors who buy a company based on blind loyalty often feel some serious hurt when its negative factors come home to roost.
Even if Company A makes your favorite product, don't gloss over its warning signs, such as dramatic and unexplained drops in sales or margins, or operating cash flow turning from positive to negative. Go out of your way to find information that contradicts your beliefs about an investment prospect. Even if you believe that Cadbury's (NYSE:CSG) has the best chocolate on the planet, research competitors Mars and Hershey (NYSE:HSY) to see just how the company stacks up. This approach will likely prove rewarding to your portfolio and your taste buds alike.
We fixate on random numbers
Bias number four is known as "anchoring" -- allowing random numbers to influence judgment. If I were to suggest that the S&P 500 is worth 500, you'd probably dismiss me, simply because the S&P currently trades around 1,300. But for most investors, myself included, this can be one of the hardest biases to shake; investors' memories of returns lost and gained tend to weigh heavily on our minds.
For example, I often regret missing out on Home Depot (NYSE:HD) a few years back, when shares were trading in the $20s. Now, whenever I see its much higher stock price, I always hope it will drop back down to the bargain-basement price it sported when I first noticed it.
Like everything in life, valuations are always changing; investors shouldn't try to encapsulate a company's value with a single number. Is Google (NASDAQ:GOOG) worth exactly $300.26? Maybe, maybe not; don't try to figure it out. Instead, come up with a range of estimated values with which you feel comfortable. Remember also that those values will change over time, as the company and its competitive environment evolve.
We base our forecasts too heavily on the past
Company A has enjoyed five years of 10% growth. What's your forecast for the next five years -- 10%, right? Not so fast.
A fifth bias is our tendency to forecast more of the same. If a company has registered annual growth rates of 10% over the past few years, we'll likely estimate similar if not identical growth going forward. Check out just about any company's Yahoo! Finance analyst estimates page for proof. I attribute this to two things: analysts' unwillingness to risk being significantly less correct than their peers (Wall Street is an unforgiving place), and their assumption that future results will follow previous patterns.
To work past this bias, investors should consider the key drivers for a company's future growth and profits. They should review how the company has been allocating available capital and the likely effect of that allocation given the competitive environment. Foolish investors should consider the probability that a company's recent actions will pay off and what the success or failure of those actions will do to the company's shares. Does management seem very positive about the future, even though Wall Street remains sanguine? Perhaps Wall Street needs to do some catching up, granting investors a value opportunity. Or perhaps management's the group with the wrong outlook.
The past doesn't predict the future -- not now, not ever. Business and the stock markets are vast and evolving beasts.
Learn from well-trained brains
At The Motley Fool, the razor-sharp analysts behind our newsletter services have far too much investing savvy to fall for these types of biases. By reading their monthly issues, you can learn how to focus on the details that really matter while avoiding the insignificant numbers that trip up the rest of the market. All of our newsletters generously offer a 30-day free trial. It's a deal no unbiased investor should pass up.
Fool contributor Stephen Ellis welcomes your feedback at[email protected]. He owns none of the stocks mentioned in this article. He admits a bias toward investing in value opportunities; fittingly, Home Depot is aMotley Fool Inside Valuepick. The Motley Fool has a bias-freedisclosure policy.
