Common mistakes, biases and other mental models

How does an investor become rich? The simple answer is by not losing money. Just to illustrate this point – a small sum of Rs. 1 lakh compounded at 25% for 25 years will become Rs. 2.6 crores. However, most investors don’t have the patience to hold on to their stocks for so long and often end up committing mistakes in their pursuit of higher returns. Greed is the enemy of portfolio growth. So how can we as smart investors avoid this fate and become richer? As Charlie Munger likes to say ‘Invert, always invert.’ We should learn from the experts and analyze our mistakes to ensure we don’t commit them again. It’s advisable to keep a track record of your investing decisions in a journal which outlines your reasons for the action. This way you can detect a pattern and know if you’re committing some mistakes repeatedly or not. Investors are also prone to some biases which can affect their portfolio. We can reduce biases when we become fully aware of them. In this post, my endeavor is to talk about some common mistakes, biases and other mental models (You can read all about mental models in our article: Investing Models that can be of immense help to you:

Mistakes:

Buying because of expert recommendation

Never buy a stock just because some ‘expert’ on a news channel or in a newspaper claimed that a particular stock will do well. We can never know their true intentions and incentives therefore we must do our own due diligence before we take a buy/hold/sell decision. We should not blame anyone else for our loss except ourselves.

Buying without understanding the company’s business

A very common error that is almost like a rite of passage for all novice investors. In their quest, to make high returns quickly, a lot of inexperienced investors buy a stock, in the hope that they think it’ll go up. This thinking is not sound and is not backed by solid understanding of the company’s fundamentals and valuation. If for some reason, the stock falls, they are left in despair and curse their misfortune instead of realizing that earning money in the stock market via long term investing has very little to do with luck.

Buying because the stock was popular

We have all heard of famous high profile tech companies who debuted at double the price of their IPO price band. A year later, most of them are down 40-60% on average. Similarly, investors bought other popular names who were media darlings without realizing that market has already priced in growth expectations and the probability of further upside is limited while downside is potentially huge. Popular stocks run the risk of significant downside because consistent profit growth in most cases is already embedded in their price. They are overvalued and should be avoided unless the investor is 100% sure of some variant perception and has a true long-term outlook.

Buying at a very high price

Sometimes supposedly cheap stocks can be expensive and expensive stocks can be cheap. This can only be determined after a proper valuation exercise. We should refrain from buying expensive stocks unless we are very confident of its superior growth trajectory and have a long-term outlook. Expensive stocks leave little margin of safety for investors and hence one needs to think twice before investing in them. Otherwise, the chances of loss is very high.

Buying a small/large position

Portfolio sizing is an important concept that we will learn later on in this course. Most investors don’t know how to construct a proper portfolio and hence they end up buying either too less or too much quantity of a stock. Thus, their portfolio ends up suffering from either excessive concentration or overdiversification. Both are dangerous and can lead to suboptimal returns for the investor.

Selling too early because of fear/greed

Just like in euphoric phases, investors are ready to buy all kinds of stocks irrespective of quality, similarly in bust phases, investors are so scared that they end up selling their precious holdings after an initial scare because of fear of further losses and greed of profit protection. While selling early is preferable to selling late, one should have sound reasons to sell and not do it for the sake of doing it mainly driven by emotions.

Selling early because of some news report

News are designed to be sensational with eye catching headlines that capture viewer attention. Majority of news that people consume today is biased, subjective, exaggerated, and not objective or factual. Facts are boring while rumors boost TRP. Hence, before we get swayed by some good or bad news, we should conduct research ourselves and check the underlying facts, then determine the potential impact on our holdings. Often some of the best time to buy a stock is when it is undergoing a temporary correction.

Selling too late and booking a loss

This is the worst thing we as investors can do. Selling too late when a stock has fallen greatly like 30-40-50% and booking a huge loss. It has a big psychological impact and can affect the investor’s confidence in his abilities. Rule of thumb: if a stock has fallen 10-15% from your buy price, face your mistake and sell it. Maybe your valuation analysis was correct and the market swung crazily, or a bear market is starting or any reason for that matter. Booking a loss at 10-15% might get you out of a few multi baggers (you can always buy them again later after careful analysis) but it will save you all the emotional pain from holding on to a stock which has lost 30-40% from your buy price.

Holding on to losers

If there are some stocks in your portfolio which have not given any returns for 3 years or have underperformed the market or are in loss – the best thing to do is to get rid of them and make space for new additions. Long term investing becomes optimal when there is a periodic spring cleaning. Stocks might underperform or move sideways for 1-2 years and that is acceptable. However, if it’s been 3 years, then perhaps the market has other hidden unobvious reasons which most investors aren’t aware of, and it’s a good sign to sell and focus on newer bets. Another Rule of thumb: never try to catch a falling knife by averaging down on your holdings. Always average up never down.

Holding on for lack of options

We shouldn’t hold some stocks because of lack of other options. By doing this we are paving the way for suboptimal returns and reducing our portfolio’s potential. Investors might hold stocks even when they know it’s not in their best interests to do so because they might be in love with it or don’t have time to research other options etc. We should have very strong reasons for each stock to be added to our portfolio.

Biases

Biases distort our thinking ability and induce us to commit the mistakes described above. So, think of them as the root cause of mistakes. When analyzing our mistakes, we must diagnose and try to get rid of the actual problem that is certain biases that have either conscious or subconsciously creeped into our decision-making process. Here are the most important ones (do note though, that they can be of use occasionally when we are short on information, and we must take a quick decision):

1. Anchoring bias: this is a tendency to rely too heavily on the first piece of information we get for decision making. All our thoughts and further decisions get clouded by this initial information. Anchoring closes our mind and makes us less receptive of new potentially relevant details.
2. Availability bias: we overestimate the likelihood of events based on their availability. If something is easy to access, understand, present widely, then we consider it to be superior to other lesser available options.
3. Framing bias: the tendency to be influenced by the way in which information is presented. This could be through different forms of media like newspapers, social media and/or some expert endorsements. Then we start looking at the information in special light.
4. Overconfidence bias: as investors when we have done our due diligence we become overconfident about the superiority of our process and tend to think we are correct and the market is wrong. Overconfidence can give a false sense of calm and affect our decision-making abilities.
5. Confirmation bias: a lot of investors hate it when they receive disconfirming evidence about one of their holdings. They become uncomfortable. They naturally seek out information which is consistent with their views when they should be doing the exact opposite of this so that they know all sides of the story.
6. Status quo bias: when we prefer the status quo and avoid going for radical shakeups because of uncertainty. This is especially important from a portfolio perspective where we might become a little too comfortable with our holdings and would want to avoid churn even if that could bring better results.
7. Loss aversion: losses hurt almost twice more than similar gains. Investors look to avoid losses rather than focus on acquiring gains. This is one of the major reasons why people often sell early upon the slightest hint of bad news because they cannot emotionally handle the feeling of loss.
8. Sunk cost bias: when we continue averaging down on a stock despite the price having fallen significantly. We tend to believe that since so of much of our time, energy and money is invested into the company, we should average down and continue holding it despite all signs to the contrary.
9. Endowment effect: the emotional tendency to consider the superiority of our portfolio holdings over their industry peers without objective facts. Since we are invested in them, our minds believe they must be great companies. This belief could end up being totally false. Hence we must constantly search for disconfirming evidence.
10. Self-serving bias: when we attribute our investing success to our acquired knowledge, experience, superior research, timing, methodology, psychology and completely ignore the role of other external factors like interest rates, luck, geopolitics, government policy etc.
11. Optimism bias: sometimes it pays to be sceptical and mildly pessimistic as this acts as a balancing force against overoptimism which can lead to an irrational belief that the stocks will only go up and never fall. Such beliefs can be very detrimental to our portfolio’s health.
12. Hindsight bias: this is common among several buy and forget investors who advocate back testing models to show it would have made sense to buy a certain stock at insane prices 10 years ago and still end up making decent gains. This bias allows us to tell a story backwards while not realizing that it is not logical because we can’t accurately predict the next 10 years based on the previous 10 year’s data.
13. Overgeneralization bias: investors love simplicity and easy to digest narratives. This is why some of the best fund managers are the best story tellers and not necessarily the ones who deliver the greatest returns. Investors have a tendence to derive broad generalizations out of limited evidence.
14. Herding bias: It takes a lot of courage to go against the majority opinion and be a contrarian. A lot of investors prefer to do the easier thing which is to follow what the market is saying and become a part of the herd. There is nothing wrong to do so as long as they have come to the same conclusion after their own independent research. However, fear of unknown, lack of confidence in own ability and sometimes sheer laziness makes investors join the herd without doing their homework.
15. Survivorship bias: every day in some form or the other, we are reminded of the successes of certain individual investors or some great companies. However, these reports tend to ignore the thousands of others who also tried and failed. The survivor lives to tell the tale and is heralded in the media, while all those who lost and no longer exist or vanished from the spotlight are completely forgotten and ignored. Stock market narratives are often built on large doses of survivorship bias.
16. Halo effect: Success in 1 field is not a precursor to success in another field. If that were the case, the same athletes would have competed in all sports. However, our mind gets easily deceived by so called ‘industry experts’, ‘economists’, ‘intelligentsia’, ‘influencers’, ‘flamboyant celebrity’ who may be successful in their respective field but don’t have any locus standi when it comes to advice on individual stocks.

I hope the above list of mistakes and biases help you in your investing journey. Remember just knowing them is insufficient, you must be fully conscious of their impact in your day-to-day life. Only when you’re aware, can you hold back and let the logical part of your brain work through a problem in a rational way.