Warren Buffett’s teacher at Columbia University, the famed value investor, Ben Graham, is famous for saying:
“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
From experience, we know this is true. If you cannot control your emotions and face up to your foibles, the sharemarket can be an expensive place to find out.
How you behave when investing often has a bigger influence than your investing knowledge. This is more relevant than ever given the abundance of information prompting investment action, combined with a dramatic increase in the ease at which investors can trade.
If investors can better understand their investing psychology – particularly the four big cognitive biases below – they will be less likely to make mistakes, such as selling too soon and holding onto losing stocks. They will also be better placed to exploit the mistakes of other investors, including picking up undervalued stocks.
Rational or normal?
At times, investors lack self-discipline, behave irrationally, and decide what to invest in based more on emotions than facts. The study of these influences on investors and markets is known as behavioural finance.
Traditional theory says markets and investors are rational but behavioural finance believes we act as humans. Or as another giant in the field of finance, Santa Clara University economist, Meir Statman, puts it:
“People in standard finance are rational. People in behavioural finance are normal.”
Behavioural finance uses research from psychology that describes how individuals behave and applies those insights to finance. Recognition of the contribution that behavioural finance has on financial economics was reflected in 2002 with the Nobel Prize in Economics being awarded to Professor of Psychology, Daniel Kahneman, now best known for his popular book Thinking, Fast and Slow.
The umbrella of knowledge under behavioural finance continues to grow and evolve. As you can see in the chart below, there are over 180 cognitive biases that have been discovered to date.
We believe that portfolio managers, and investors in general, need a firm grasp of four key biases to understand how other investors may respond to particular events or market developments.
1. Overconfidence (buying too high and trading too much)
The overconfidence bias is when we delude ourselves that we are better than we really are.
Surveys routinely show that more than 80% of people think they are better than average for a whole list of things, including driving, intelligence … and even looks. Heck, 84% of the French believe they are above average lovers!
In investing, overconfidence can lead you to believe that you know more about a stock …….