The Risk Management Lessons: 2. Mastering The Mind

by: Matthew Allbee

Summary

Over the Summer, I will be writing a series of articles on risk management - taking investors from the basics all the way to topics such as Modern Portfolio Theory.

In this second article, I talk about the many psychological biases investors must overcome to behave rationally in their investment decisions.

Mastering these psychological biases is essential to profitable investing.

Without the ability to discern when you are falling victim to your brain, your investing will forever be controlled by its primal instincts and unable to profit consistently.

Perhaps one of the most important aspects of an investor's risk management is to learn how to control his or her own psychology. The financial markets have a time-tested history of separating the psychologically unprepared investor from his money and giving it to those who have mastered their minds. Learning to tame the mind's natural tendency to fall into certain irrational behaviors is possibly the most important lesson that every investor must learn.

So, in this week's risk management lesson, I've decided to go over some of the most common psychological biases that investors fall into when engaging the markets. With a better knowledge of how your brain can try to trick you, you can eliminate a substantial amount of errors.

Loss Aversion Bias

Loss aversion is the tendency for people to feel the pain of losses more strongly than the joy of equal profits. This can cause us to avoid certain investments we should take, while also remaining in investments that we should sell.

For instance, if you are presented with the offer to receive $110 if a coin flip lands on heads or pay $100 if the coin flip lands on tails. Rationally, because both the chance of winning $110 and losing $100 are the same, you would choose to accept this offer knowing that it is statistically profitable. Many people, though, will not take the bet, because they know that the possible pain of losing $100 is more than the joy they would have from winning $110. Their brains are so loss averse that they will instinctively misjudge a statistically profitable strategy to be unprofitable!

This applies to investing as well. If you believe a stock as an equal chance of gaining 25% or losing 20%, you may very well choose not to invest in it even though a simple statistical test, adding 25+20 and dividing by 2, shows that you can earn an average of 2.5% on investments of this type. Even though the strategy is overall profitable, your brain will tell you not to take the risk because it is afraid of feeling the pain of loss.

Loss aversion can also cause investors to stay in a bad investment for too long. Not wanting to feel the pain of losing, your brain may try to convince you to stay in a losing investment in the hopes that it will turn into a winner. This is how small losses can become devastating.

Herding Bias

"Herding" is the process by which individual investors choose to believe the consensus of the market just because the market believes it. This phenomenon is an artifact of our primal heritage - it was almost always safer to follow the crowd, so we learned to instinctively believe whatever the common opinion was.

Unfortunately, when herding occurs among investors, it can have serious consequences. All stock market bubbles were likely, at least in part, the result of herding. Each individual investor chose to believe whatever the crowd believed and bid up stock prices much higher than their intrinsic worth. When the crowd's opinion suddenly swings bearish, these bubbles pop.

Herding doesn't only occur in stock market bubbles, though. Every time an individual investor chooses to buy or sell an investment just because the general consensus is that it will be profitable, that investor is under the influence of herding bias. To avoid this bias, force yourself to write down why you believe an investment is worth buying or sell before you make the trade.

Overconfidence Bias

Overconfidence bias usually occurs after a winning streak. People have a tendency to evaluate their ability more positively than it actually is. This causes investors to overestimate their investing ability, often with poor consequences.

For instance, an overconfident investor may believe he can consistently beat the market even when he has no proof to suggest this is true. With too much faith in himself, this same investor may choose to leverage his "sure-thing" positions and end up blowing his entire account on an inevitable losing streak.

To avoid overconfidence bias, it is important to make sure that your beliefs and decisions are grounded in hard fact. If you have no hard evidence that you are good at investing, you shouldn't believe that you are. Of course, if you have no hard evidence that are an unprofitable investor, you shouldn't believe that either.

Confirmation Bias

Confirmation bias occurs when we come to a conclusion before we find the evidence. Instead, we seek out evidence that would support the conclusion we've already come to and discount any evidence that goes against it. This, again, leads back to overconfidence bias. Because we've discounted all contrary evidence, we are overconfident that our ideas are correct.

For this reason, it is important both not to come to conclusions on an investment before knowing the facts and not to discount evidence that goes against your belief. This can be easier said than done. A good rule for eliminating confirmation bias is to search for as much evidence that goes against your belief as possible. If you still have the belief, it is much more likely to be true.

Recency Bias

Recency bias causes us to only take into account the recent past when evaluating an investment. This can cause us to make mistakes by discounting important events that occurred farther back.

For instance, an investor may believe a retail company that has a surprisingly good quarter of sales is suddenly underpriced without taking into account the massive amounts of debt that the company had accrued over the last five years. They would then overvalue the company and possibly lose money by purchasing a stock that is not actually undervalued.

To avoid recency bias, it is important to take a "whole" view of investments before deciding on whether or not to buy. By forcing yourself to look at a complete overview of the investment, you are more likely to discover and account for negative factors from the more distant past.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.