Preventing biases and heuristics from imperilling our investment decisions.
All investing opportunities contain return and risk prospects at varying proportions. Ideas of investment opportunities with lucrative returns and zero-risk prospects are figments of the imagination of those whose intentions are to swindle naïve investors. Successful investing is all about getting the odds in our favour, which means finding opportunities where chances for high returns are much greater than the risk materialising.
However, substantial research into investor behaviour has found that most equity investors (around 70 per cent) lose money in the market. Investors might lose money differently, but the common theme is the failure to get the odds in their favour. Even an informed investor has the same proclivity for the mistake as the naïve investor. Influenced by many biases and heuristics, the informed investor assumes that the odds are in his favour when they are against him.
Affect (noun): emotion or desire as influencing behaviour.
Our emotions and desires are the dominant impetus behind our biased thinking. They cause us to see favourable odds in situations where there are none and thus make poor investment decisions. Similarity, proximity, familiarity, and temperament are major factors that could cause us to like certain people or ideas. The same factors prompt us to develop a liking towards certain investment themes, narratives, or ideas. Such liking (or disliking) doesn’t necessarily have to serve our best interests.
Once a positive or negative Affect is developed towards an idea or a person, the chances for a distorted or biased view of reality are higher. We downplay risks influenced by positive Affect and exaggerate risks influenced by negative Affect, neither of which are in our best interest, causing us to make poor investment decisions. We buy stocks that we shouldn’t be buying… avoid stocks that we should be buying… buy stocks when we should be selling… and sell stocks when we should be buying… When influenced by Affect, the professional (sophisticated) investor and the amateur (naïve) investor behave alike in a self-sabotaging manner.
Affect has an overwhelming influence on our investment decisions when we are pressured by circumstances characterised by high uncertainty. Too much information to process or situational urgency might also demand that we rely on Affect for decision-making.
We are usually docile to the Affect system because of some of its very tempting features. Being emotional, Affect is automatic, easy to use, and provides quick judgements, allowing us to act quickly. Humans are naturally inclined towards such systems of decision-making. However, such quick decisions are unlikely to be effective, particularly regarding investment decisions.
Employing our slow and deliberate rational-analytical system to the situation would help in making better decisions. However, when influenced by Affect, under the influence of strong positive or negative feelings, we are biased in our thinking and mostly attempt to use our rational-analytical system to rationalise what Affect suggests.
Overcoming Affect through effective coping mechanisms is imperative for making better investment decisions. A recommended coping mechanism is being aware of strong feelings, whether positive or negative, as they arise within us but not succumbing to them, and then sitting them out. Affect could operate insidiously too, which means we are unaware of its influence on our decision-making. Having a checklist can help in such situations. Evaluating a stock against a checklist, an analysis checklist that lists the fundamental drivers of a stock’s long-term prospect is another constructive coping mechanism for escaping Affect’s entrapments.
Our investment portfolio must deliver superior long-term returns, which requires us to make several effective investment decisions. Affect is a leading obstacle in achieving this objective. Affect delivers a distorted understanding of a stock’s prospect, and decisions based on such perspectives are ineffective.
Effective decisions depend on a clear understanding of a stock’s prospects. Only insightful analysis can provide an accurate perspective. The path to ‘Insight’ is partially cleared once we overcome ‘Affect’. ‘Affect’ is an emotional bias that imperils effective decision-making. Additionally, various cognitive biases too distort our understanding, leading to ineffective decisions.
The following articles describe the thirteen most common cognitive biases and how each causes systematic errors in our thinking and judgements: https://www.verywellmind.com/cognitive-biases-distort-thinking-2794763
We need to make many decisions in our everyday lives including trivial ones such as when to wake up, what to have for breakfast, which shirt to wear for work, and whether to carry an umbrella today; to deliberately think through each of them every time is impractical. Instead, we rely on heuristics to solve this problem. Heuristics are mental shortcuts learned from our daily experiences that help us make quick decisions without the hassle of deliberately thinking through every situation.
‘Buy Low, Sell High’ is a common simplistic heuristic in investing. It implies that a stock’s price is considered low if it has recently declined a lot and is worthy of buying now. The inference that the price is low is made by comparing it to the high from which it had declined.
But the assumption that the price will regain its previous high is wrong. The price might have declined due to weakening fundamentals and excessive valuation, and hence the price to decline further might have a greater probability than regaining its previous high. In fact, ‘Buy high, sell higher’ has a greater likelihood of success than ‘Buy low, sell high’ because a recent trend is more likely to continue than reverse.
Sudden and sharp price movements are more likely to gain our attention than slow and gradual moves. When our enquiry reveals that a positive earnings surprise coincided with a sharp and sudden price movement, we associate the two. Thus, a heuristic is born: ‘Buy stocks that report positive earnings surprises because high earnings growth is positive for stocks’, another prevalent heuristic in investing.
The powerful influence of this heuristic on stock prices is evident in the sharp price increase after a positive earnings surprise, which reinforces our belief in the heuristic. But in most such cases the rally fizzles out within days because only sustainable earnings growth could deliver long-lasting stock returns, and a single quarter’s positive earnings surprise could either be part of sustainable earnings growth or not; most likely it is not.
Since the rally fizzles out gradually and slowly, it is less likely to gain our attention than the sudden rally; therefore, the relevance of the heuristics is less likely to be questioned. Even if you intentionally pay attention to the gradual fizzling of the rally, you are unlikely to find a convincing cause behind the fizzling. A heuristic remains credible so long as counterfacts that disprove it are absent.
Sustainable earnings growth does not result from any single factor but culminates from the confluence of several conducive factors aligning favourably within the company over an extended period. Being aware of those conducive factors is important. But mistakes happen when we wrongly infer certain irrelevant factors as conducive. Most of these mistakes happen when we form beliefs or reach conclusions based on very few of our most recent experiences. We could have a different, more accurate understanding if we consider a larger sample of the occurrence of such incidents presently and over time.
The IPO market illustrates this point well. Authoritative research into IPO investing reveals that 40 per cent of IPOs lose money in the first year of their listing and 70 per cent of them by the third year. Against this fact, investors’ ever-present fascination with IPOs seems preposterous.
Psychology could explain this vain disposition of investors for IPOs. Suppose you have applied for six IPOs: one delivered a 100 per cent listing day gain, another a 150 per cent listing day gain, and the other four delivered poor or mediocre returns. The chance for superior listing gains within your experience sample is just 33 per cent; if you seek out much larger samples outside of your experience, you will find a much lower probability.
The two IPOs that delivered superior listing gains are extreme results, which always gain more attention than less extreme, but more common results. The two IPOs that delivered superior listing gains surely evoke strong positive feelings within you, while the others don’t. Since experiences with strong feelings have more memory recall, when you think of IPOs later, only the IPOs that delivered superior gains come to mind. This could explain investors’ ever-present fascination with IPOs despite the odds tilted against them.
Our brain has a predilection for seeking out causes and patterns among events, even among random events where no cause or pattern exists. The brain then cherishes the coherent, convincing narrative constructed out of these causes and patterns. The brain’s propensity for such narrative construction is an attempt to escape the anxiety induced by the uncertainty, ambiguity, and randomness inherent in most worldly events.
However, apart from the comfort our brain finds in such narratives, they also lead to misunderstandings, inaccurate judgements, wrongful conclusions, and ineffective decisions. This disadvantageous inclination could largely be overcome through an awareness and acceptance of the pervasiveness of uncertainty, ambiguity, and randomness in most worldly affairs. We behave the same whenever we learn something, whether from the most reputed source or the most naivete: we accept them as true if no counterfacts exist to negate them immediately.
Scepticism (noun): the quality of being not easily convinced; having doubts or reservations about the truth of something.
Scepticism is the best antidote to avoid being misled by our biases and heuristics. Maintaining doubt is not our brain’s natural inclination because it involves uncertainty, which the brain finds discomforting. So, the brain rushes towards a conclusive and coherent narrative with limited information, which might be convincing but unlikely to be accurate. Maintaining doubt (scepticism) about emerging facts, their sources, our beliefs, and the decision-making process could to a certain extent purge biases and heuristics’ adverse influence on our decisions.
Slowing down, deliberately going through the process, and a sceptical attitude are essentials of an effective decision-making process. But attaining this requires effort. We must compete against the brain’s natural inclination to “jump to conclusions”; for “quick and impulsive decisions”; a “craving for certainty”; and a “credulous attitude towards new information and ideas”. Additionally, the powerful influence of Affect, cognitive biases, and heuristics on our decision-making makes our quest for effective decisions even harder.
We need to make informed and effective investment decisions to achieve better returns from the stock market. It is a probability game won by getting the odds in our favour. Believing that the odds are in our favour when they really aren’t is the leading cause of most investors’ failure at equity investing. Affect, cognitive biases, and heuristics aid and fuel those inefficacious tendencies within investors.
Our perception broadens when we slow down. Slowing down also improves our self-awareness. The resultant mindfulness could facilitate effective, rational deliberation of a situation or problem, which alongside a sceptical attitude improves our chances of getting a favourable odd.
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