Seventy-five years ago, Benjamin Graham identified the value approach to investing in the books Security Analysis and The Intelligent Investor. In that time, the value approach created many billionaires and one mega-billionaire (Warren Buffett). However, even with its widespread adoption, the ubiquitous growth of computing power and plethora of freely available financial data, value investing continues to show significant outperformance of the market.
What could cause this advantage to persist when the value approach seems so established and well-worn? The advantage persists for the same reason that existed when Graham first identified the opportunity: human beings behave irrationally. While the tools to identify value have progressed dramatically, the human mind has not. We are all prone to the classic (and very expensive) human biases that have been with us since our predecessors emerged from the caves.
Here are the top 22 biases that can destroy your portfolio (see how many you can personally check off):
1) Denial: Once locked in, irrational investors hate admitting they’ve made a wrong decision. It’s an ego thing. So they hang on to losers, even refuse to sell losers. Alternatively, it means you are not as smart as you thought. Regardless of what it means to you, it is a losing proposition.
2) Attachment: You fall in love with “special” stocks. You exaggerate virtues, downplay problems and then hold on too long.
3) Extremism bias: Irrational investors have trouble assessing risk, often bet big, and lose big. Probable events become inevitable. Unlikely events become impossible. So you are likely to miscalculate your risks.
4) Anchors: In your mind you tend lock in price targets, like a $100 stock or Dow 18,000, then minimize any data that suggests you’re wrong.
5) Ownership bias: Once purchased, you value what’s yours even higher, like overvaluing your home. That blinds you to the real value, adds to your losses.
6) Herd mentality: For all the talk about macho individuality, the truth is most investors do not think for themselves and tend to follow the crowd, or blindly track some trend.
7) Getting-even bias: You lose, then you try to break even taking extra risk, doubling-down. You get overanxious, overreact, and you lose more.
8) Small-numbers bias: Making decisions on limited data that’s incomplete and likely exaggerated.
9) Loss aversion: Many cautious people tend to avoid losses more than seek gains. That fear keeps investors out of the market too long and in “safe” investments such as Treasury bonds or money market accounts.
10) Pride: You hate selling losers, hate admitting error.
11) Risk averse: You take too little risk after a big loss or a losing streak, get too conservative, don’t trust yourself and miss opportunities for higher returns.
12) Myopic bias: You think recent data is more important than older information. So you may pull back after a losing streak, or ride a winning streak till you lose it.
13) Cognitive dissonance: You filter out bad news and tend to ignore and discard new information that conflicts with your biases, preconceptions, and belief system.
14) Bandwagon: You disregard fundamentals. You think you understand “momentum.” You conclude that “so many” followers cannot possibly be wrong.
15) Confirmation: You’re not only critical of any news that contradicts your beliefs, you blindly accept any data that confirms expectations.
16) Rationalization: You are super-logical and can marshal lots of evidence to back up whatever you first decide to buy, even if it’s based on limited logic and data.
17) Anchoring bias: You rely too much on readily available data, just because it’s available, even when you know it could be faulty.
18) House money: You treat winnings as if they belong to the house or casino. Then you take bigger risks, giving it all back, and then some.
19) Disposition effect: You tend to lock in gains and hang onto losses, selling shares in an upward-trending market, hanging onto losers too long, similar to loss aversion.
20) Outcome bias: You judge your decisions on results rather than the context when you made the decision. That’ll result in misleading you the next time.
21) Sunk-costs bias: You treat money already invested in a stock as more valuable than future opportunities, so you often hang on rather than sell and reinvest.
22) Perfect behavioral storm: Separately, each bias is bad enough. Combined, they become bubbles, set you up and wipe you out. Either way, financial ‘experts’ can easily manipulate you into what they want, blowing bubbles and popping them without you ever knowing what’s happening … manipulating you like a mindless puppet.
OK, you probably have a rough idea of how many of these biases with which you identify. For example, let’s say you estimate that out of this list of 22 known investors biases, you’ve irrationally made investment decisions based on just five of these bad habits and biases. That is far more than enough to explain the times when you lost significant money while investing. The point is that there are many, many ways in which the subconscious, emotional aspect of your human brain can trick you into making mistakes in your investment approach that cause you to lose money.
What’s the solution? In the words of Warren Buffet, America’s value investor extraordinaire, “An investor will succeed by coupling good business judgement with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.”
IntelligentValue.com provides you with business judgment based on 30+ years of equity analysis and portfolio management, insulating you from mistakes rooted in the biases listed above. We’ll provide detailed stock selection based on quantitative analysis that identifies the best investment opportunities and combine that with rules-based market-risk analysis to avoid the worst return-destroying drawdowns.
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