Behavioural economics or behavioural investing is a relatively new science. There are plenty of cognitive biases people have which don’t always lead to the most optimal or rational decision.
In Behavioural Investing I and Behavioural Investing II, we have covered:
– Herd mentality
– Loss Aversion
– Confirmation
– Anchoring
Below are two more human behaviours that influence people’s investment decisions.
Hindsight bias
Hindsight Bias or the “I knew it all along” effect is to view a past event as being predictable even if there was no basis for predicting it. You fool yourself into thinking you knew it all along “it was obvious” that the event would occur.
Among investors it can lead to overconfidence and an unfounded belief they have superior investment picking abilities. We all need to admit our susceptibility.
To become a good investor you need to objectively evaluate all your investment decisions, both good and bad. For me, this means setting out the reasons in writing why it is a good investment before you buy or the reasons for selling before you sell. Then in in the future your evaluation of the decision made is more likely to really reflect your actual thoughts unclouded by hindsight.
Extrapolation
Extrapolation or recency Bias is when you put more weight into what occurred recently than what may have occurred in the past.
It is hard for us to see the future in any other direction than a straight line. It is easy to take what is happening currently and project it forward. When the reality is a myriad of possibilities.
A company has a string of negative information being reported about it. This may be temporary but investors will have a biased negative expectation about the stock and miss the fact that it may be temporary or miss the early improvement signs. They would lose an opportunity to buy a stock at a price below its intrinsic value due to the bias. This also works when a stock has run up strongly (why won’t it continue?) even though the price may now be well above its intrinsic value.
One of the many disclosures investment professionals have to make when marketing their products on performance is “Past performance does not guarantee future results” this disclosure is required because of this bias.
The future performance may well continue but there are many other factors at play and you need to understand them before committing your capital to them.
The good new is once you start to recognise this Biases you can start to minimise their impact.
Recommended further reading:
“The Little book of Behavioural Investing” by James Montier