Over the last few decades, we have developed a plethora of sophisticated financial technologies to help us better engage the markets. The depth, breadth, speed, and precision with which we can now gather and analyze information stands virtually unmatched. Yet on a comparative scale, investors today haven’t performed any better or worse than they had in decades past.

Without a doubt, our digital technologies have bumped-up the investment game a few levels. But given the general lack of progress in most investor performance, perhaps a critical part of successful investing has little to do with advanced technology or analytics. Perhaps it has more to do with our own habits of mind–those instinctive cognitive tendencies that influence, perhaps even direct, our every action from the substratum of conscious thought.

 

How Biases Shape Our Perspectives

We all have certain tendencies to judge situations according to our preferences; to prejudge a situation based on what want to see versus what we are actually seeing. In short, we all have biases. Perhaps it stems from a basic human instinct to fixate on and react to danger and opportunity. What drives our biases is a matter of theory and debate. Leaving that topic to the researchers, let’s go with what we experience on a daily and practical basis.

Our perception of the world combines our capacity for original thought with our tendencies to sense things according to habitual preference–the latter being our biases. We can effectively think and plan around abstract situations, particularly those separated from real-time experience. But when those situations become imbued with a sense of uncertainty and risk, as in the case of implementing an investment strategy, our capacity to maintain a rational frame of mind has its limitations.

 

Thinking Risk Versus Experiencing Risk

For when we experience risk, in other words, when we truly feel the onset of danger at a given moment, our biases, along with our instinctive “fight or flight” responses, tend to kick in and shape, if not entirely reframe, our perceptions; often overriding our more rational powers of thought. Let’s take a look at some of these cognitive tendencies and how they can negatively affect one’s “investing intellect.”

 

Losses Feel Much Worse Than Equivalent Gains

If you were to guess, what would you think might have more of an emotional impact–a 10% loss or a 10% gain? Given the equivalence of the figures, albeit one negative and the other positive, you’d assume that the emotional intensity of both might be correspondingly similar but in opposite directions. According to studies done in the field of behavioral finance, losses are felt two and a half times worse than equivalent gains.  

Suppose you purchased bitcoin currency in early 2017 with the goal of holding a long-term position. Acknowledging bitcoin’s potential as an increasingly popular medium of exchange, you were also aware of the possibility that speculative interests may have caused bitcoin prices to bubble. Then came the announcement in September that China was banning Bitcoin; a big problem considering that a large majority of Bitcoin mining takes place in China.

The ensuing -35% drop in just 14 days would have frightened any investor. But for many if not most investors, the drop, according to certain behavioral finance researchers, probably felt like an -87.5% drop–two and a half times worse than the actual figure.

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Many Bitcoin investors and users fled the currency, disregarding the initial long-term view they held. Many of them might have paid more attention to the effect of the speculation-driven plunge or the fundamental uncertainty that took place in a single (albeit large) country, forgetting the original reason why they had purchased bitcoin in the first place: as an unregulated “global” currency, one promising transactional freedom, privacy, and efficiency, and whose viability or credibility rested on the individual peer-to-peer blockchain networks that support it.

Those who stuck with the currency, long-term value in mind, saw Bitcoin rebound in four weeks for a 76% gain from the bottom of the correction. Bitcoin gained more than 1,400% in 2017.

Hindsight Makes Us Feel As If Past Events Were Predictable

When we obsessively fixate on particular stocks in a portfolio that are performing either remarkably well or poorly, something strange can happen. We get a sense of deja vu; a sense that, somehow, we just knew certain stocks were going to outperform or underperform the rest. We tell ourselves…”if only I followed my gut instincts…”

But rarely can an investor claim to have predicted both winners and losers, let alone predict specific stocks that ended up winners and losers. Why? Because such predictive powers are an illusion of hindsight.

One of the biggest dangers facing investors when it comes to this hindsight bias is that it may fuel the impulse and overconfidence to tweak their portfolios based on a gut response to current events, rather seeing their investment strategy through, as had been initially planned under the light of clarity and reason.

Let’s imagine a scenario in which an investor holds a portfolio that, on average, is performing well. Despite the portfolio’s relatively strong performance, it nevertheless consists of 60% winners and 40% “losers.” Now let’s say that within those two groups, the investor is fixated on two stocks. Stock ABC is up 20% while stock XYZ  is down 15%. If the investor’s tendencies are like those mentioned in the study above, then a 15% loss (multiplied two and a half times) might feel like a 37.5% loss.

While the loss continues to nag him, he comes to the realization that he knew stock ABC was going to be a winner. The fundamentals made sense from the beginning. So if he was successful in predicting a few of the stocks that performed well, why not apply that winning formula to most if not all of the stocks that are dragging his portfolio down. Why not sell the losing stocks? Why not rebalance the entire portfolio?

The problem here is that the investor is not seeing the fact that his portfolio is in the black. He’s also blind to the fact that his prophetic powers, which can turn against him at any moment, are an effect of hindsight.

 

Taking Too Large a Risk and Seeking Reasons to Justify It

It’s important to note how hindsight bias can easily lead an investor into feeling overconfident about making rash decisions based on a gut feeling. With reason out the window, such false conceptions can sometimes trick investors into making one of the biggest errors in investing: placing too much weight on a single, or limited set, of stock positions, thereby abolishing any advantage of diversification that may have been present in a portfolio.

By the way, how large is too large? There are several criteria aimed at accurately identifying what might constitute an excessively overweight position for a given investor. A conservative opinion might consider that anything larger than a 5% allocation toward a single stock would qualify as being too large.

So, if most investors don’t have the professional knowledge, experience, or resources to justify the risks of large position sizes, how do they go about assessing their options and justifying their choices? Assuming objectivity has been dulled by overconfidence, many investors tend to “cherry pick” market data that confirms their gut sense about a given stock, regardless of any compelling fundamental information that may be pointing to the contrary. This is called confirmation bias, and many investors fall victim to it all the time.

This bias has led many investors to unwisely hold onto stocks through long periods of downturn; seeking optimistic data to confirm their opinions toward a market that has clearly and fundamentally turned against them. Imagine the investors who experienced this in the 1980’s during the long energy bear market. For those who held on, disregarding the industry fundamentals that could have warned them, it took about a decade for investors to see their stocks return to their pre-drawdown levels.

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The takeaway: short-term gut responses have no place within the context of a sound investment strategy. They undermine the rational groundwork upon which reasonable selections, allocations, and risk expectations have already been built. Furthermore, they appeal to factors of sentiment and bias; both of which are vulnerable to the sway of market fluctuations; and both of which work against the long-term vision and goals that define the purpose and function of the investment portfolio.

 


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