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LESSON SUMMARY
In this lesson, you will learn about the different biases that would affect your decisions as a stock investor. You’ll quickly see how you’re often your own worst enemy, and how knowledge about biases will do wonders to your investment returns.
LESSON TRANSCRIPT
Welcome to the 6th Lesson of the Asset Allocation Course. For this lesson, we’re going to talk about biases and stock investing. Thinking rational about money is not as easy as it sounds. Think about it like this. Imagine that you’re sitting in a conference room and two people just got up from the audience right now and stormed out. Well, you might find it a bit odd, but you probably wouldn’t think too much about it. Perhaps they had an important phone call to make. Who knows? Instead, let’s imagine that everyone aside from you, stormed out of the same room. It would only be you sitting there all by yourself. What would you do? Well, you would like to think there was something that you didn’t know about and you will be running for the hills, right?
We, as people, are influenced by what other people do and say. There was really no way to get around that. Even the great Sir Isaac Newton, undoubtedly one of the greatest minds and one of the most influential scientists of all time, lost all his money in investing because he couldn’t control his emotions. Long-Term Capital Management was bailed out for billions and billions in the potential biggest crash in history that looked to take down the entire American financial system. They couldn’t control their emotions despite being led by Nobel Prize-winning economists.
The first bias I would like to talk about is loss aversion. One of the most severe problems that we have as stock investors are how we perceive the winners and losers in our portfolio. What we tend to do is to sell our winners and double down on our loses. Meaning, that if we buy a stock (say Google), and we make a 10% return, we are compelled to sell it. It makes us feel good. We can tell ourselves and other people that we invested in Google. We feel good about the narrative, and we feel good about making that investment. Perhaps if you saw the price go up 10% and one quarter, we could even tell our friends that we made 40% and a return in that position. So, what do we do? A lot of people would sell their stock. We leave the cast though it could be invested elsewhere and we even incur a capital gains tax. So, we say to ourselves we made a great return, but perhaps we should rather ask ourselves whether or not we sold a long-term winner instead and there are few reasons for this.
One of the problems is that we are less inclined to buy into Google again despite being a potentially good company. So, say that the price went up another 10%. We might have a hard time buying into it. After all, we don’t want to buy in at a higher price than what we sold for, right? And we don’t want to spoil that good history of making that great investment. That way, we might end up being punished twice from a winner because of our biases. It gets even worse when it comes to losers. We had the idea I think we haven’t made a bad investment before we have sold the stock and we can sell the score.
In other words, if we bought a stock at a $100 and the cricket slides to $80, we say to ourselves that we haven’t lost anything and we might even double down since it’s now trading at a lower price. I’m sure everyone at stock investing is familiar with this. You don’t consider the opportunity cost of investing in something else. You just wait for that stock to turn into profit and you completely disregard that you might have invested in another stock today if you had to do it all lower. When we talk about buying our winners and selling our losers, we’re not talking about momentum investing. It’s not about riding a soaring stock price. It’s a way of saying that if the market agrees with us on our picks or a long-time span and the company keeps improving, we should strongly consider if we should add more and vice versa. If the stock we bought plummets, we should ask ourselves if everyone is indeed wrong and they might be. But often, the business has changed, and you are the person that’s simply wrong.
So, when it comes to loss aversion, this is my key takeaway: Keep adding to great businesses that emerge as winners and sell your losers and stop paying the opportunity cost. This requires that you’re objective about the true state of your stock, and that also takes me to the next bias. It’s the bias known as confirmation bias. Confirmation bias is not only present in stock investing, but every part of our lives.
Imagine this: You are buying a new car after lengthy research. In the weeks after, you ordered the car and you find yourself seeing a lot more similar cars out on the roads which you feel pretty good about. You also find yourself finding several articles about that specific car and how it has performed in various tests. If that doesn’t sound familiar, perhaps you’ve been exposed to confirmation bias just within the product. It could be a new phone, a gadget, or something like that. Confirmation bias is confirming what we already know or at least think what we know. Why is that a problem in stock investing? Well, just as we confirm our own thesis about a product, we tend to do the same thing about a stock.
Imagine that you just bought stock in Apple. If you’re still searching for information about the stock after you’re taking a position, how do you filter the information? Well, you will definitely find a lot of positive articles about the stock, and you will tend to agree with these analyses. If you do find a negative analysis, you will read them with an “I’ll prove them wrong kind of approach,” finding fault everywhere so that your original thesis about the stock won’t be disregarded. As a stock investor, you have the deck stacked against you because another problem is that very few people in the finance industry has an interest in you not being invested in that stock. You broke over as they tell you to buy stocks, perhaps specifically Apple, since they’re making money and trading that stock and the analyst who wrote the report might also invest in the same stock or has another interest in promoting it. So, in the first place, there is an old weight of material that highlights the positive case for that stock perhaps more than a balanced approach.
And I would like to clarify it that you see this problem for Apple, but you also see it for all the stocks out there. So, to sum up with “confirmation bias,” you believe too much in what you already think you know, and you’ll lose the capability to search for the truth.
