Thursday, 26 November 2009

Five Common Investor Judgment Errors and How to Counter Them

Humans are hardly the rational decision makers of classical economic theory. Researchers have catalogued numerous systematic and repeated errors of judgment that people make when investing. Far from being considered outlandish such conclusions are now mainstream. The research has already garnered a Nobel prize in 2002 for Daniel Kahneman and Vernon Smith. It has also become confusingly vast - see the scores of entries in Wikipedia's List of Cognitive Biases and on the Behavioural Finance webpage.

That's all well and good, but the average investor wants to know what are some of the common mistakes and, more importantly, what can be done to minimize or avoid the bad effects.

1) Loss Aversion - often manifesting itself as refusing to admit to a mistake (which some Nortel investors who hung on too long may relate to), it arises from the curious fact that a loss apparently is felt twice as much as a corresponding gain. The pain of losing a dollar is perceived as much worse than the pleasure of gaining. As a result, investors typically hang on too long to losing stocks and sell too soon after a gain.
Countermeasure: establish buy and sell points in advance when first making the investment. This can be a price target, both on the upside and the downside, which can be made automatic with limit orders. Or the buy/sell trigger can be a financial ratio such as Price/Earnings. The mere act of trying to figure out the action point will probably improve the quality of the initial decision in addition to avoiding the psychological trap of loss aversion.

2) Extrapolation Error - this is the mistake of blindly projecting into the future the pattern of the past, especially the most recent past. This error can consist of extending a negative trend, like "the market is crashing, it won't stop or go back up", or a positive trend, as in the technology bubble that many thought could not end. The error can also apply to individual stocks - assuming that a company which has done well for many years will continue to do so may not be realistic. Witness the post on the comings and goings of the top companies in the TSX over the years.
Countermeasure: a) examine assumptions directly - ask yourself what has underlain the success or failure of the past and question whether that will continue to be the case; b) build best case and worst case scenarios and see whether you would still be comfortable with the outcome if it should happen, especially on the downside; it may be necessary to revise the worst case downwards as conditions evolve - again, the downward progression of Nortel over the last eight years may be instructive. In the early years its demise did not seem at all probable but as successive management teams failed to right the company the outcome became more likely.

3) Anchoring - we all set a point of reference against which to make judgments, often whether we realize it or not, as MIT professor Dan Ariely reveals in his popular book Predictably Irrational with some amusing examples of experiments he conducted. The reference point may be misleading. That having the thought of a higher social insurance number in one's mind could influence upwards the price that savvy MBA students would be willing to pay for unrelated items like wine and computer equipment sounds unlikely and incredible, yet that is what happened. As investors we can trick ourselves into judging whether a price is high or low by looking at the wrong indicator. For instance, the 52 week high-low range of a security's price is a dangerous measure of whether the current price is cheap, whether one anchors on the high or the low. Those past bounds give no guide to the future.
Countermeasure: research the true value of the security, such as by working bottom up with fundamental analysis methods to estimate the price of a security.

4) Nostalgia aka Rosy Retrospection - this error consists of shifting the blame for our portfolio losses to "the market" rather than our choice of investments. And on the positive side, we may take all the credit for good outcomes, whether or not that was true.
Countermeasure: at the outset, make written notes on expectations and the reasons behind them. Later it will then be possible to examine the result against the real initial thinking, as opposed to our faulty rosy memory. To learn from mistakes is a mark of any good investor and we should all seek to do so - e.g. the acknowledged top investor Warren Buffett almost revels in fessing up to his blunders.

5) Optimism Bias - this is the forward-looking counterpart to rosy retrospection. Good outcomes are judged to be more likely than they merit while the possibility of bad outcomes is downplayed. People who are successful in one field, like physicians, engineers, lawyers, athletes etc are especially at risk of thinking they can easily repeat their success in investing.
Countermeasure: look at both positive and negative aspects of an investment. List the pros and the cons, and especially the possible things that could make an investment go wrong. If there are no cons in the list, that should tell you that you have almost surely missed something as there are few free lunches in this world. A question to ask: "if I am willing to buy, why are other people willing to sell at this price?"

A few other sources to amuse and inform on how our brains can mislead us:
  • The Secret Language of Money by David Krueger, M.D. and John David Mann - a psychologist explores how our thinking goes awry and offers practical advice on how to improve judgement in handling money and investing.
  • Mean Markets and Lizard Brains by Terry Burnham - explains the irrational errors made by our "lizard brains" of our evolutionary past and then incorporates current macroeconomic factors to give specific tips on how an investor can thereby profit.
Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.


Michael James said...

It's true that people have irrational tendencies and some are better at controlling them than others. However, rational people tend to do better financially than irrational people. As a group, wealthy people are more rational than people of average means. So, the average dollar is more rational than the average person.

CanadianInvestor said...

Michael, now there's an interesting topic for discussion. Is it rationality that makes people wealthy on average. Or is it luck, confidence, chutzpah?

John Connolly said...

One trend in warning signs concerning Canadian Public Companies, which investors might want to observe, I believe, is the tendancy for large successful ones to attract U S investors who may form a group, or be lead by a U S take over specialist.

It's usually not long after they obtain a large voting block of common and/or preferred shares that they begin taking a hand with the board and key officers. Next an American (or British etc.) President is installed; and he begins to replace line management with Americans.

That's a large part of what kiboshed Massey (Harris)Ferguson and Nortel. The new management may be experienced, nice people; but they may also all lack any profound commitment to to the company, or to life in Canada. Company aircraft begin to appear, shuttling execs to Toronto or Vancouver Monday afternoon and back home Friday morning. And of course money bags, the raider, keeps hollering for better results at any cost, this month.

If an ornament to the Dominion like Conrad Black gets involved, pining for a peerage in Britain, a similar syndrome plays out.

David Krueger MD said...

Great summary article.

Neuroeconomics and behavioral economics, especially when combined with quantum physics and strategic coaching, contribute significantly to understanding mind matters and brain business.

One of the greatest challenges s that so many of the methods to facilitate change are contrary to the way our minds and brains work.

For an additional perspective on this Blog topic:
Sleep On It: The Neuroeconomics of Striking When The Iron Is Cold

CanadianInvestor said...

Thanks for the link, Dr. Krueger. Enjoyed the book a lot.