For Higher Returns, Avoid These 2 Investment Biases

Includes: BB, KO
by: Andrew N. Smith

Investors braving the markets must be attentive not only to fundamentals and trends, but also to their own psychological tendencies. The fields of behavioral economics and finance have taught us that decision-making biases have the potential to significantly affect investment returns. Thus, engaging in some metacognitive reflection before pressing that execute button is likely in your best interests.

One common bias, which has to do with risk-attitudes, is explained in Kahneman and Tversky's (1979) renowned article on Prospect Theory (Kahneman won the 2002 Nobel Prize in Economics for this stream of research). Prospect Theory suggests that people treat the potential for gain differently depending on whether they are situated in a profit or a loss position. If they are in a loss position, they will be more risk-seeking, whereas if they are in a profit position, they will be more risk-averse.

Without question, this is a bias that has affected my investment decisions. For example, I purchased shares ($50.00 pre-split) in Coca-Cola (NYSE:KO) during September, 2008 when they were somewhat depressed from the financial crisis. I held them through December, 2011 up to $68.47, but sold them then because I thought the run was over and wanted to lock-in the profit. In hindsight, had I been less risk-averse and held on to the position until August, 2012, I could have liquidated my position at a much higher level (above $80.00 per share).

As an example of risk-seeking in a loss position, let's look at Research In Motion (RIMM). Ouch! I initiated a position in RIMM in April, 2011 at $51.51 per share. It seemed like a good value opportunity, the markets were doing well (see overconfidence below), and I was looking to take on a little more risk. The stock continued to suffer, making the value appear even better, so I initiated a second position in October, 2011 at $20.38 per share. We all know how this one has turned out so far. RIMM is now trading well below $10.00 per share, and I continue to hold both positions. Rationally, I believe I should be liquidating these positions; however, I haven't been able to push the button yet because the hope always remains, and what's left to lose when the position has already declined so significantly? There's always the potential for a BB10 rebound, right?

My behavior in both examples is well explained by Prospect Theory: risk-averse in a gain position and risk-seeking in a loss position. The key to dealing with this kind of bias is to remain disciplined and independent of one's position or expectations when analyzing an investment opportunity. Easier said than done, in my experience, but at least with awareness comes the potential to make better decisions in the future.

A second common bias afflicting many investors is overconfidence: they overestimate their ability to achieve above-benchmark investment returns. Overconfident investors jeopardize returns by underestimating risk, trading more frequently, as well as over-reacting to private information and under-reacting to public information (Chuang and Lee 2006). For example, in the case of RIMM above, I over-attributed my overall investment returns to my own stock-picking decisions and under-attributed them to the general rise in the market. These attributions made me feel confident in my abilities, leading me to underestimate the risk of purchasing a declining technology stock like RIMM.

Overconfidence is even associated with some interesting phenomena, such as investors over-allocating investment funds to their sector of employment, leading them to take on undue risk and experience depressed returns (Dǿskeland and Hvide 2011). So you, as a marketer - for example - might think that you posses asymmetric information about Kraft (KRFT) or Clorox (NYSE:CLX); however, in all likelihood you are overestimating the uniqueness and precision of that information and its potential to impact the movement of those stocks.

So how can you reduce overconfidence (Arkes et al. 1987)? One way is to receive feedback on your performance by keeping track of the good, the bad, and the ugly in your portfolio; it is, obviously, important to be honest with yourself when engaging in this process. A second way is to think through and prepare an argument about your decisions (assuming a critical audience). This potentially forces you to both elaborate on your reasoning and engage in counter-factual thinking. Seeking Alpha seems as if it can play a role in both of these strategies, particularly the second. The message here, then, is: don't be shy to share your analysis and opinions because it could make you a better investor!

In conclusion, there are a number of biases - including those related to risk-attitudes and overconfidence - that can impact your investment decisions. Developing an awareness of these biases, as well as strategies for mitigating them, should help you to improve your potential for higher investment returns.

Disclosure: I am long RIMM. 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.

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