Warren Buffett states that "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ". Instead, what gets people into trouble is their temperament and making the wrong decisions.
Yet, once you are aware of it, you can actually control these biases which in turn can have a pretty big impact on your returns.
Sunk Costs
The sunk cost fallacy theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.
One example of this would be if we purchased expensive theater tickets only to learn prior to attending the performance that the play was terrible. Since we paid for the tickets, we would be far more likely to attend the play than we would if those same tickets had been given to us by a friend. Rational behaviour would suggest that regardless of whether or not we purchased the tickets, if we heard the play was terrible, we would choose to go or not go based on our interest.
Our inability to ignore the sunk costs of poor investments causes us to fail to evaluate a situation such as this on its own merits. Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses. Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.
Anchoring
Ask New Yorkers to estimate the population of Chicago, and they'll anchor on the number they know--the population of the Big Apple--and adjust down, but not enough. Ask people in Delhi to guess the number of people in Mumbai, they'll anchor on the number they know and go up, but not enough. When estimating the unknown, we cleave to what we know.
Investors often fall prey to anchoring. They get anchored on their own estimates of a company's earnings, or on last year's earnings. For investors, anchoring behaviour manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.
When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it. We may cling to subpar companies for years, rather than dumping them and getting on with our investment life. It's costly to hold on to losers, though, and we may miss out on putting that invested money to better use.
Pat Dorsey in an earlier interview gave another angle to this. We hang out with people who think like us. And in investing, that means if you feel good about the market, you probably read a bullish investor. To counter this bias, you literally need to read about points of view and listen to individuals who make your tummy ache. They make you feel bad, because they're disagreeing with you, and frankly their point of view says, you might be wrong. But that is really valuable information to know.
Confirmation Bias
Another risk that stems from both overconfidence and anchoring involves how we look at information. Too often we extrapolate our own beliefs without realising it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favorably.
For instance, if we've had luck owning Maruti cars, we will likely be more inclined to believe information that supports our own good experience owning them, rather than information to the contrary. If we've purchased a mutual fund concentrated in health-care stocks, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.
Hindsight bias also plays off of overconfidence and anchoring behavior.
This is the tendency to re-evaluate our past behaviour surrounding an event or decision knowing the actual outcome. Our judgment of a previous decision becomes biased to accommodate the new information. For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. This type of "knowledge updating" can keep us from viewing past decisions as objectively as we should.
Mental Accounting
If you've ever heard friends say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action. Most of us separate our money into buckets--this money is for the child’s marriage, this money is for our retirement, this money is for the house. Heaven forbid that we spend the house money on a vacation.
Investors derive some benefits from this behaviour. Earmarking money for retirement may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we categorise our funds without looking at the bigger picture.
One example of this would be how we view a tax refund or a bonus. While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously. Since tax refunds are in fact our earned income, they should not be considered this way.
If our taxes were correctly adjusted so that we received that refund in portions all year long as part of our regular paycheck, we might be less inclined to go out and impulsively purchase that flat-screen television.
In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance, or realized capital gains.
Framing Effect
One other form of mental accounting is worth noting. The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect our decision.
Let's assume, for example, that we decide to buy that television after all. But just before paying Rs 50,000 for it, we realise it's Rs 10,000 cheaper at a store down the street. We would definitely make that trip down the street. If, however, we're buying a new set of living room furniture and the price tag is Rs 5 lakh, we are unlikely to go down the street to the store selling it for Rs 4.90 lakh. Why? Aren't we still saving Rs 10,000?
Unfortunately, we tend to view the discount in relative, rather than absolute terms. When we were buying the television, we were saving 20% by going to the second shop, but when we were buying the living room furniture, we were saving only 2%. So it looks like Rs 10,000 isn't always worth Rs 10,000 depending on the situation.
The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments, and to take care not to think of your "budget buckets" so discretely that you fail to see how some seemingly small decisions can make a big impact.
This is an extract from an article which initially appeared on Morningstar's U.S. website.
