Due to the way you think, be it because of evolution or your nature, your mind set many traps for you.
And, unless you are aware of them, the traps can greatly limit your ability to think rationally and make intelligent investment decisions.
Your first step to overcome these traps is to be aware of them and then putting reminders or check-lists in place for you to avoid them in future.
Here are five of the most harmful thinking traps for investors, and how you can avoid them:
1. Over-optimism and Over-confidence Traps
This is the most common trap investors are victim to. Not only are we over optimistic, but we are over confident as well.
Over optimism and overconfidence come from the illusion of control and the illusion of knowledge.
The illusion of control refers to our belief that we have in an influence over the outcome of uncontrollable events.
For example why are people more likely to buy a lottery ticket if it contains numbers that they chose rather than a random collection of numbers?
The illusion of knowledge is a tendency for us to believe that the accuracy of our forecasts increases with more information.
The simple truth is that more information does not equal better decisions, it’s what you do with it rather than how much you have that matters.
Each of these traps is bad enough on their own but together they present a dangerous combination. They lead us to:
- overestimate our knowledge,
- underestimate the risk, and
- exaggerate our ability to control the situation.
These two traps have really cost me dearly. I found that the more research I have done on a company the more certain is it has made me that my investment decision is correct. This made it extremely difficult to reverse my decision in spite of negative information and the share price moving against me. To the contrary it made me see every new low as a wonderful buying opportunity.
What I have over time forced me to realise is that I know less than what I think, irrespective of how much time I have spent analysing an investment. If I am unsure I ask a friend or colleague to do an independent analysis and I then force myself to consider his findings.
What I have also implemented is a stop loss system based on my purchase price and trailing price basis to stop me from riding winners all the way down.
With the strict stop-loss as soon as an investment has lost 15% I review the position and should the loss reach 20% I seriously consider selling.
For the trailing stop-loss (this means a stop-loss calculated from the highest share price) I seriously consider selling should a 25% loss be reached. I specifically used this strategy for investments in higher risk companies or when I think the market is overextended and I want to protect my profits.
The best way you can counter these biases is to consciously make yourself aware of them and to learn to think in terms of probabilities rather than absolutes.
Additionally always adjust your view giving greater emphasis to the possible risks.
Following these guidelines have most likely lead to me making smaller gains but I am more than happy to accept those rather than take excessive risks or losses.
2. The Anchoring Trap
Studies have shown that when we are faced with uncertainty we will grasp at almost anything to help us form an opinion.
In terms of investing our biggest problem is ignoring the current share price when evaluating an investment.
Once you know the current share price it is very difficult to independently calculate a fair value price using any valuation method as you have a tendency to skew the analysis so that the current share price is reached.
This is a very difficult bias to defeat. The best way to do this is to rather than to calculate towards the share price calculate in the other direction.
For example when doing a discounted cash flow, rather than trying to calculate a discounted share price, take that the current share price and calculate what forecasts are built into the current price, then compare this growth rate with what you’ve independently forecast for the company.
If you can, the best way to counter this bias is to forget market prices look only at the financial information to calculate a fair stock price. Good luck, I have found it nearly impossible to do.
3. Loss Aversion Trap
This is another bias that strongly affects us, especially when investing.
We hate losses and we will try to avoid them whenever possible. What makes this even worse when investing is that a loss is not perceived as a loss until it is realised.
This leads to the tendency for you to hold onto your losers and sell winners. Even if you are right and a losing investment becomes profitable again there will be an opportunity to buy the investment at a low price rather than ride the position all the way down.
The best way we can counter this bias is to sell our losers and hang on to winners.
This is very much easier said than done.
The way I counter this is to follow a strict stop-loss strategy as mentioned above.
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4. The Confirmation Trap
We are inclined to look for information that agrees our opinions. This thirst for agreement rather than the opposite is known as the confirmatory bias.
It feels good to hear our own opinions confirmed, but this is not the best way to make decisions.
I know I’ve made this mistake. As soon as I’m interested in the company I tried to look for articles where somebody has expressed the same opinion.
What I now try to do is look for people that have written something on exactly the opposite what I want to do.
For example if I want to buy I look for people writing sell motivations and if I want to sell I look for people that have written something about buying the stock.
The key is to look for the devil’s advocate opinion and carefully incorporate these arguments into your thinking.
You have to learn to really listen to those that do not agree with you.
Something I discovered recently that has helped me to not fall in this trap is to not form am opinion on a company but rather remain objective and look at all the negative and positive arguments on the company. It is hard but will keep you more objective.
5. The Hindsight Trap
Another bias that leads to self deception is the hindsight bias.
It’s easy for you to think of your past decisions and think that it was simple, comprehensible and predictable to have made a choice. The faith in your ability to forecast the past gives rise to yet another bias, that of hindsight.
The best way to counter this bias is to keep in mind that you didn’t know it all along even if you think you did.
The past, seen from the present, was just as uncertain as the future is from today.
This is the trap that usually drives investors over the cliff in sharply rising markets such as the internet bubble. Investors think their decisions are infallible and keep on investing, making bigger bets, due to past successes.
I do not have a good idea as to how this bias can be overcome other than to say it pays to err on the conservative side rather that rely on confidence gained from past decisions.
Always keep in mind that you may be wrong.
So in summary
You know less than you think you do
Forget the current stock price, work out what the stock is worth
Sell your losers and ride your winners
Listen to those who don’t agree with you
You did not know it all along you just think you did