Being successful in the stock market requires not only good to be good at evaluating the fundamental merits of companies, but also requires to be psychologically strong. Greed and fear are (arguably) the two most important emotions that are present in the stock market. The ability to manage both of those emotions is essential to a successful investing life, which leads to comfortable retirement.
This article touches the psychology of the markets. The emotional side of the markets that affect each and every human investor. More specifically, it explores common emotional and thinking biases that both retail and professional investors are exposed to.
The idea of the article is to educate the community about three scientifically discovered investor behaviors and to offer approaches to correct it. The first step to correct biases is to be aware of them. Being aware that they exist is essential. This article intends to make the Seeking Alpha community aware of common behavioral biases.
1) Confirmation bias - selective thinking
It is the idea that investors notice and pay more attention to information that confirms their previous beliefs. Particularly after forming ideas that require hard work and considerable effort, investors tend to cling to their beliefs. Obviously, it is important that investors stay true to their beliefs. Well-formed beliefs and viewpoints are correct pretty often. However, having an open mind to consider the possibilities of an adversary belief can go a long way in having a successful investment life and retirement. The consequences of ignoring a contrarian argument when it is valid can be damaging to total returns.
Furthermore, confirmation bias can extend beyond just paying attention to information that confirms investor's belief. It also takes the form of selective thinking, which means that information is processed and searched for in a way that confirms one's belief. In a research study published by the American Psychological Association, psychologists prove the existence of confirmation bias. They demonstrate that confirmation bias affects how information is processed after decision-making. That is, after an investor decided to buy (or sell) a security, information is processed to confirm the prior decision.
One example of confirmation bias is when investors fall into a value trap, where the low price multiples appear to tell that the purchase is a bargain. However, considering the industry and competitors could expose the reasons for a low multiple in a company. Perhaps the company's product is no longer competitive. Therefore the earnings will continue to fall, along with the multiples and the price. If investors simply look for information that confirms a company is undervalued (price multiples in the example), then they may fail to consider the reasons why a company has low price multiples.
The best way to correct confirmation bias and selective thinking is by being aware that the bias exists. Acknowledging that one might fall under selective thinking is the first step. The next step is to search for adversary information. Asking the question "in what ways could my thesis be wrong?" can help investors identify the types of information that could pose a threat to their beliefs. More importantly, being aware of potential threats to an investment thesis can help investors stay on the right track to achieve retirement goals.
The Seeking Alpha community is a great source for contrarian information. Since Seeking Alpha is an open source project made up of intelligent investors, it is probably one of the top places in the internet to find contrarian thinking.
2) Availability bias - heuristics in judging probabilities
Refers to the idea that investors use easily available information to reach conclusions about possible outcomes. In other words, one uses heuristics to turn a complex decision into a simple one. It is much easier to make decisions based on the available information than to go above and beyond to search for new (or essential) information. The main outcome of availability bias is that one might use shortcuts to reach conclusions about probabilities.
In a paper published in the journal of psychology, Nobel Prize winner Daniel Kahneman and Amos Tversky argue that memory is one of the most important heuristics that one might use to judge probabilities. Because recent events resonate in one's mind, it is easy to use recent events as source of information.
For example, one might think that the stealing of data by hackers is a likely event. After the Target data breaching event, one might think the probabilities of businesses being hacked are very high. Therefore jump right into buying a company in the cybersecurity industry. In reality, such hacking takes thousands (if not millions) of attempts before succeeding. Furthermore, not all cybersecurity companies protect businesses from hackers.
The scientists also argue that because one lives and sees a small portion of the world at the time, one is susceptible to use small samples to explain the outcomes of a large population. In the recent Chipotle scandal, one might think that Chipotle has lost all of their customers because they see the nearby restaurant is now empty. In reality, the nearby restaurant is one out of thousands of restaurants. While the information might give clues, such a small sample might not be representative of the entire population. One might jump to the conclusion that Chipotle lost all of their customers, and sell the stock. In reality, Chipotle might have lost customers, but the trend could be temporary or not even significant.
Availability bias can be taken further. It also represents the reliance on easily available information to make decisions. One example is the reliability on calculations of price multiples, such as price-to-earnings (or P/E). Since it is much easy (and readily available) to look for a company's P/E on Yahoo! Finance than it is to calculate it, the human nature to use heuristics would make it tempting to take Yahoo! P/E as given. However, a P/E ratio has to be considered along with accounting standards and normalized earnings. There are many factors that go into EPS and some of them might need to be adjusted to have a reliable P/E. Automatic databases (like Yahoo! Finance) tend to omit those adjustments.
The first step is to correct availability bias is to recognize it. The next step is to develop a strategic and systematic plan for investments. Such a plan should have realistic investment goals, the length of the investment period (time left until retirement), and the return that needs to be achieved to fulfill the investment goals. Finally, investors should have an open mind and consider all possible alternatives, and not just easily available alternatives. For example, one might want to research international stocks ETFs in order to diversify away from domestic stock markets.
Once again, Seeking Alpha is a good option because it offers a variety of alternatives. Seeking Alpha articles are a good place to find an area that could merit further research.
3) Hindsight bias - selective perception
Refers to the idea that the outcomes of some events appear to be more predictable than they really are because one thought so before it happened. In other words, hindsight bias refers to the I-knew-it effect. Investors tend to make quick hypothesis on their minds, regardless of whether they act on it or not. When some of those quick hypothesis actually evolved the way the investor thought, it gives the impression that the event was much more predictable than it really is. This is related to selective perception. Investors only perceive the information that makes their hypothesis true, while forgetting about all the ones that did not turn out to be true.
In a paper published in the Journal of Experimental Psychology, psychologists took hindsight bias to a next level. They proved that humans update their knowledge based on the outcome of an event. In this case, scientist argued that the imperfections of memory allows one to "fill in the gaps" with the facts that are known.
For example, let's suppose an investor formed a hypothesis about Apple (NASDAQ:AAPL). He believes that AAPL will appreciate on the back of selling laptops, and does not give much credit to iPhones. A few years after the fact that Apple has grown mainly due to unprecedented growth of iPhone sales. He might "update" his past knowledge and claim that he knew that iPhone sales could surprise. Due to memory imperfections, the investor "filled in the gaps" with known events.
Hindsight bias can be dangerous to investors. If quickly formed hypothesis turned out to be true, then the investor might think that the market is more predictable than it really is. As a result, one can take action based on hindsight bias and not based on fundamental research.
The key to avoiding hindsight bias is to understand it. If investors simply know that they are susceptible to hindsight bias, then they can recognize it when it happens. The next step is to be honest with oneself and recognize when a sudden hit was due to chance. Taken to a higher level, investors might want to keep a journal of their decisions along with their key reasons for the decision. After some time has passed, compare the decisions with the real event. The results might be surprising.
Key investor takeaways
Whether you are an active or passive investor, be aware that emotional biases apply to every human being. Everyone feels emotions, whether retail or professional investors. Awareness of the emotional aspect of investing is as important as understanding the fundamentals. Retirement is a marathon, not a sprint. Being aware of the obstacles investors will face in the future, and the emotions that are likely triggered from those obstacles, and how to deal with such emotions, can ensure that the marathon is finished successfully.
One last thing, always remember that luck is when opportunity and preparation meets.
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.