Modern portfolio theory assumes the individual to be rational when making investment decisions. At all times, the investor is able to digest all relevant information and immediately comes to the same conclusion as other investors in the interpretation of such information. As a result, this set of new information is instantly reflected in security prices and characterizes the essence of modern portfolio theory: market efficiency.
On the other hand, the psychological predisposition of an individual contradicts his rational decision making capabilities. A wide range of cognitive and emotional biases are very likely to lead to irrational investment actions. It is striking, and speaks to the limitations of group thinking or herding, that at times of volatility irrational decision making is reflected by the collective. If markets are truly efficient, why would stocks fluctuate to the extent that they sometimes do? And how about periods of extreme volatility? Behavioral biases are the reason why most investors defeat themselves by buying in a boom and selling in a bear market. Why is it so difficult for the average investor to position himself more intelligently?
Why does the investor insist to want to buy Facebook or LinkedIn (LNKD) or any other trend stock at an extreme and almost ludicrous valuation but would never want to buy AIG (NYSE:AIG), Bank of America (NYSE:BAC), Citigroup (NYSE:C) or Research in Motion (RIMM) at steep discount from a conservative book valuation?
The reason for this is simply your psychological makeup. The overwhelming majority of investors make emotional rather than rational, reflected decisions. This behavior leads to significant mispricings of securities that we see in varying degrees of quantity. There are a variety of biases that are probably profoundly contradicting your investment success:
Overconfidence bias: You think, you know it all. For a variety of reasons, you think you can interpret information better than others or have more/better information.
Confirmation bias: You are selectively looking for confirming and ignoring contradicting evidence.
Conservatism bias: You are hooked to your old forecasts when new information would merit a re-evaluation of your prior forecasts.
Regret aversion bias: You are submitting to the majority opinion and do what everybody else does...such as buying Facebook. You follow the herd, because as part of the herd you can fail silently.
Control bias: You assume you have more control over your investment outcomes as you really do.
Availability bias: Depending on how e.g. investor presentations are structured and presented you give more credit to the most recent (i.e. positive) information.
Loss aversion: You hold a loser for too long or sell a winner too soon, leading to high portfolio turnover, high transaction costs and higher taxes. Loss aversion also implies risk-seeking behavior.
How can you mitigate these effects and be more successful in investing?
The first step is to simply raise awareness about your imperfections. The more you can emotionally detach yourself from your investments and their outcomes, the more likely you will succeed. It is one of life`s great ironies that the one who is willing to take calculated risks and make a loss is the one who gains in the end. The investor who is getting shaky when his position is down 10% will probably not last for very long. Secondly, it materially improved my own investment performance over the years when I started to think of booms and busts as a pendulum that swings from fear to euphoria.
Thirdly, you have a concrete tool at your disposal that helps mitigating those biases and making your investments work for you: Checklists. Some time ago, I developed a checklist of all the characteristics a suitable investment for me should have. A couple of points of my checklist are listed below:
1. Is the stock hated, neglected, misunderstood and ripped apart in the mainstream media?
2. Let us be constructive: Are problems overblown, concentration of bad news?
3. Does a credible business model exist and for how long?
4. Does the company have an influence on the industry? Market share, history?
5. Good earnings and book value growth record?
6. Reputation of the company under normalized conditions?
7. Does management under-promise and over-deliver?
8. High insider ownership? Excessive management compensation?
9. Did I do my homework, did I read the necessary documents 10K, 10Q, SEC filings, did I seek contradicting evidence, do I understand what I am dealing with and what I am doing?
Only after I answer all questions with YES I am entering into an investment.
Mitigating those biases is not as hard as it seems as long as you follow a structural approach to invest intelligently, on both an intellectual and emotional level.
Disclosure: I am long AIG.