As investors, we are biased. So are you.
This is not a negative thing.
Bias is simply a state of mind.
Whether you have chosen a business, a career, or a specialization in a particular field as a vehicle to build and develop your wealth – you are biased.
And that is okay.
As long as you have the conviction, and the force of will to follow through with your choice, then that is fine.
Bias however, in the absence of checks and balances is dangerous for those among you who choose to use the stock markets as an investment.
We can become too short-sighted. We can become too greedy.
And it is in our nature to be human.
Yet being human in the stock markets can lead to losing nearly 90% of your investments.
Each of the above stocks sings a cautionary tale: your human bias left unchecked can destroy your investment capital and/or your retirement nest egg.
Discounting events outside of your control (such as a hurricane destroying the business you invested in), how do you avoid painful investment mistakes?
- How do you control your bias?
- How do you safeguard yourself against your bias actively, all the time, and without failure, while generating super-normal returns?
The answers are straightforward.
But they will require some explanation.
1st: The answer to how you control your bias is to first know what they are. Only then can you counter-act them.
2nd: The answer to how you can safeguard against your bias actively without fail while generating super-normal returns, is to simply use a proper investing framework.
In this article, I will show you exactly how to do both.
Bias #1 – Anchoring: Are You Allowing Brand Anchoring to Cloud Your Judgement?
Suppose today I asked you to guess the population of Johor Bahru.
Without using Google, how do you go about guessing it?
One thing you could do is to start with something you know.
You know Singapore has about 5.8 million people. JB is about 27 times larger based on land mass. Maybe they have 27 times the number of people?
So that would say about 156.6 million people (27 x 5.8 million)?
Now lets think about it from the perspective of someone in say, Penang.
Penang is roughly half the size of Johor Bahru. So maybe, if you were from Penang, you would have guessed twice of Penang’s total population, which is about 3.534 million people.
How are the numbers so different!?
One has guessed 156.6 million people. The other has guessed maybe 3.5 million people.
Yet both were guessing at the population size for the same place! (The actual population of Johor Bahru is actually 502, 900 people. Both the Singaporean and the person from Penang would have been dead wrong.)
This process is known as Anchoring and Adjustment.
You start with a number you know or guess, and you adjust in a direction accordingly. And you do this everyday.
The bias happens when you fail to make sufficient adjustments. People from a more populated city repeatedly guessed larger numbers, while people from smaller cities repeatedly guessed lower numbers.
Anchoring and adjusting clearly failed them.
Here’s another fun fact: a group of college students were once asked two questions in an experiment.
They were first asked, “How happy are you?”
Followed by, “How often are you dating?”
When students were asked in this manner, with happy being first, and how much dating being second, the correlation was 0.11.
In other words, how happy a student is, was only explained by how much often they were dating, roughly 11% of the time.
Guess what happened?
The experimenters decided to flip the questions around.
First they asked, “how often are you dating”, followed by “how happy are you”, and this time, the correlation was 0.62.
This meant that 62% of the time, how happy a student is was directly related to how often they were dating.
This didn’t make sense at all!
The questions did not change. Yet changing the order of the questions immediately shifted the perception of the students!
Apparently, they must be very unhappy if they are not dating as often as they would like! Yet they did not feel that way when they were asked the questions in a reverse manner!
The first question anchored the second. Clearly, Anchoring and Adjusting is a dangerous bias to have.
So how does this relate towards investing and your life?
On Your Daily Life:
When charities ask you for a donation, they typically have a range of options: $50, $100, $200, $300.
If the fundraisers had any idea of what they were doing, these numbers would not be random. The bottom tier is the anchor.
Had they engaged a psychological science graduate (like myself), I would have perhaps designed a process even more robustly “persuasive”.
In a manner as subtle and as neutral as possible, I would have started with “Are you a good person?”, followed by “would you donate to a worthy cause as a good person” and then followed by, “how much would you like to donate?”
As it stands, a similar study was done using this method.
People were asked, “Are you helpful?” followed by “Would you kindly help me with this survey?”
There was a 76% increase in survey participation versus the average survey attempt by the person on the street.
Nothing stops you from donating just a single dollar.
Or just saying no.
Do you personally anchor high prices?
Maybe you think you don’t.
If that is the case I’d encourage you to think back to the last time you paid for your iPhone, or your other premium smartphone, your branded watch, wallet, bag or shoes, pen or expensive item.
Did you set the anchor for the price on those products?
Or did the businesses do it for you?
When you head to the stock markets, you can see such irrationality on display as well in the stock prices.
Haidilao International Holding Ltd (HKG: 6862) currently trades at a price multiple 75.47 times of its earnings.
Put another way, IF Haidilao earnings do not grow, then it would take the company 75 years to see the investor’s money fully earned inside of its profit and loss statement.
That’s not even taking into account that what a company earns isn’t pure profits. It has cost of sales too. It has to pay rent. Pay for electricity. Pay for staff. Pay for cost of goods.
In comparison Facebook (NASDAQ: FB) has a price to earnings of 27.97.
And people thought Facebook was a hot stock!
Do you see the irrationality now?
“Oh its Facebook/Apple/Amazon/Netflix/Google/Haidilao/DBS/Blue-Chip/Hyflux (government stamp), it must be worth the price!”
Key Takeaway: Do not allow a stock’s brand to “anchor” you. And don’t let it “adjust” your perception of its true value. Learn to calculate the intrinsic value of a stock by itself without looking at the brand of the company.
I would bet that most people would not be willing to buy a restaurant business trading at 75 times its price-earnings. Yet all of a sudden they are willing to do so when its HaiDiLao!
Bias #2 – Availability: Past Events Affect Future Assessment
In assessing risk, people tend to assess the likelihood of risks by asking how readily examples come to mind.
Purchases of home insurance goes up in the aftermath of floods, hurricanes, earthquakes and national disasters – even in areas where natural disasters were not prone to happen.
Driving fatalities rose sharply in the aftermath of the September 11, 2001 attacks.
The underlying belief was to avoid air travel since the memory of the terrorist attack was fresh in their minds.
People who decided to not travel by air evidently forgot that travel by road had a much higher chance of fatality.
How does this relate to investing for you?
First ask yourself the question of whether a stock market crash is likely in the next 5-10 years.
Whether your inherent answer is yes or no, you are biased.
The correct answer, no matter what, is to stay invested in the stock markets, and that stock market crashes, in the long run, do not matter.
As can be seen from the info-graphics, the mystic arts of predicting market crashes are better left to the whims of fate.
Investor bias, or the Availability Bias flies in the face of this.
If the markets had recently been bearish, investors would feel fear, apprehension and negativity. If the markets had recently been bullish, investors would feel optimistic, happy, and positive. Such a behaviour encourages the mistakes of “Buying High, Selling Low”.
After all, when you’re happy and positive, you buy more stocks. Not less. When you’re negative and fearful, the natural tendency is to sell your stocks. Not buy more.
Counter-intuitively, the best time to buy stocks is when the market crashes. And the best time to sell stocks is when the market is at a high.
When you ask yourself if a stock is likely to go up or down based on the event of past performances, you are making an investment mistake.
Instead, learn to rely on the fundamentals of the stock, which will give you a higher probability of success.
Remember your Availability Bias: Hyflux tripled its share value from 2008-2010 before it ultimately plummeted through the floor, wiping out 34,000 Singaporean investors in one fell swoop.
Investors who thought that it could continue its rate of growth and failed to look into its fundamentals were grossly mistaken and the market punished them for it.
Bias #3 – Optimism and Overconfidence Bias
MBA students regularly rank themselves in the top ten percent of any performance related metric.
Since they are MBA students, that is normal – to them that is.
What doesn’t make sense is that most of them think they will fall in the top ten percent.
Only 10 out of every 100 people fall into the top 10%.
This is fact.
Yet almost always, MBA students feel they can beat the odds.
This “overconfidence” effect does not apply only to MBA students.
Investors and people all over the world alike are similar.
“I am better. I am faster. I am smarter. I am above average.”
90% of all drivers think they’re better behind the wheel. Nearly everyone thinks they’re funny. 94% of professors surveyed believe they’re better than the average professor.
- What do drivers who think they’re above average do? They drive more carelessly – and consequently get into more accidents.
- What do students who think they’re smarter do? They study less, and achieve more mediocre results.
- What do drinkers who think they’re above average do? They drink more.
And what do investors who think they’re above average do? They take on increasing amounts of risk. They grow complacent. Then they get wiped out.
Don’t assume that you’re better. You’re most likely not. Don’t allow your overconfidence and optimism on any single stock to dictate your investment.
Bias #4 – Disposition, Losses and Gains
Look at the following and choose one:
- Receive $900
- 90% chance of winning $1000, 10% chance to get $0.
If you chose to take the $900, you are certifiably human.
And yet probability determines that the expected outcome between choosing both is the same.
What does this tell you?
People tend to zoom in on “certainty” and are risk-averse when seeking gains.
We would rather get a sure win than have a lesser chance of winning more.
Perhaps more importantly, we are also even more irrational in dealing with losses: people would rather engage in risk-seeking behaviour to avoid a bigger loss.
You see this behaviour everyday in the stock markets. People prefer REITs with “good sponsors” over other valuation metrics – even when data disproves that good sponsors can lead to higher returns for investors.
What happens consequently?
Investors suffer losses. Or take home less returns.
Learning Lessons Summarised Conveniently For You
|Biases||How They Affect You||How to Prevent It|
|Anchoring||Branding or other marketing effects can make you believe a price is “justified||Remember Haidilao, with a PE of over 70. If you’re not willing to buy a hotpot restaurant business at an expensive price, why are you willing to do the same when I attach the name Haidilao to it?
Check for the intrinsic or true value of a company before buying it.
|Availability Bias||You make judgements on the possibilities of risk based on more recent events.||Prior to the housing bubble crisis of 2007, investors were ecstatic and optimistic beyond belief in the market.
We all know what happened next. Just because something hasn’t happened, or has happened, does not mean that it will or won’t happen again.
The future is uncertain. It cannot be predicted.
As an investor and as a business owner through the stock markets, you must be willing to own the business through bad times and good.
You must also know what you have invested in. Do not let past events dictate future actions.
|Optimism and Overconfidence Bias||You tend to believe you’re exceptional compared to the rest of the world. |
Few investors are. Notably, even Warren Buffet makes mistakes with his investments. He openly admitted to missing out on tech stocks because it is a sector he does not know or understand and he sticks to what he understands.
You are not as exceptional as you think you are.
|A favourite quote among more seasoned investors is to be greedy when others are fearful and fearful when others are greedy.
The next time round you catch yourself being overly optimistic or having a strong belief in a particular stock, ask yourself if you have done your homework. If you have, and you’re confident, great. If you haven’t, you better questions why you’re so certain in this particular stock. Dig into the financials of the company.
If you haven’t dug into the financials of a company – don’t invest in it.
Much less be optimistic or overconfident about it.
|Dispositions, Gains and Losses Bias||You tend to place more emphasis on certainty, and you might take more risky actions to avoid losses. |
You also tend to keep losers too long and sell winners too early.
|Nothing is certain in the markets. Buying into “sure win” companies is not something any investor I ever respect have ever said.
The next time someone tells you something is a “sure win”, you best question it thoroughly.
Note that you also need to enter into any investment with a strategy as to when to cut your losses.
Let your winners run. Cut your losers out. Don’t do the opposite.
3 Big Reasons We Choose To Use The Factor Investing Framework
We favour Factor Investing for three key reasons.
#1 – Research Proves It Works. And Buffet does it too.
In fact, it’s so good, that even the greatest investor of all time, Warren Buffet himself has on a mathematical level, followed factor investing’s paradigm.
You can read more about factor investing evidence here.
#2 – Factor Investing Removes Human Emotions from the Investing Process And Allows Focus
By using numbers alone to dictate what can, and what cannot be invested in, we are able to remove human emotions from investing.
This is important because most people are inherently unable to separate their emotions from their money.
Using the true value of a stock matched against its current share price, we can determine Buy, Hold, or if we’re invested, whether we should sell.
We don’t decide based on a gut feel. An instinct. A feeling. Nor do we try and evaluate it based on subjective aspects such as “brand”.
A week ago, I had the good fortune of meeting a friend who’s stock portfolios were taking a massive hit due to the ongoing trade wars.
Apple had dropped from $198 per share to $187 and Alibaba had dropped about $177 to about $169 a share on Friday.
He was justifiably (to him) upset.
Owning 10,000 shares of each meant that the trade wars had just costed him close to $90,000 on Apple and about $80,000 alone on Alibaba.
A loss of about $170,000.
What my friend failed to realise – and what I had to gently remind him of – was that he had bought Apple back in 2007 at $26 per share and Alibaba back in 2017 at about $87 per share.
Based on his invested share price, he was perfectly fine.
Yet, he remained distraught for the remainder of the evening.
Remember when I mentioned people tend to place greater emphasis on losses over gains?
This is a prime example.
In Factor Investing, we remain focused on the fundamentals of the stock we are targeting. We have a defined holding period. We have a defined sell price. And we have a defined buy price as well.
In fact, if Trump had been any kinder and tweeted more about the trade wars, we would have been happier to watch stock prices drop.
Warren Buffet happens to share the sentiment.
And while the earnings of a company can change rapidly, the assets of a company change far more slowly.
Trump’s tweeting would have effectively allowed us to gain further profits because he would have lowered our entry price.
Factor Investing, when followed precisely allows you to ignore market tugs on your emotional strings.
It lets you FOCUS past the frothing surface of the ocean and down into the seabed, where the true treasures are.
That’s why we use Factor Investing.
#3 – We Avoid Information Paralysis
The Pareto Principle is a general rule of thumb about distribution effects: generally, 20% of efforts is responsible for 80% of the results.
In the world of investing, information is everywhere. News. CEOs. Government announcements. Mergers. IPOS. Business contracts. Insider selling. Insider buying. Corporate actions. Big company acquisitions.
The list goes on and on for an investor to look at.
Yet, few people ever really consider simply evaluating the business and looking at its financials.
In Factor Investing, we determine share price by looking at the company’s fundamentals. And by looking at its competitive liabilities under its profits, as well as how expensive it would be to own.
By following the factor investing framework, we are able to sift out only information we require to make an investment.
In this article, we’ve covered some of the egregious logical errors investors new and old commit when they are in the markets.
- We’ve taught you how to avoid them.
- We’ve taught you how to look at them.
- And we’ve taught you how to be wary of them.
If you want to know exactly how we do it, you can sign up for a free seat to our intro-course here. Alvin Chow, our CEO will be demonstrating Factor Investing live on the workshop.
If not, I hope this article has at least opened your eyes to the logical traps that are constructed within your own mind when you approach stocks.
Trump’s waging a trade war currently, and China is happily retaliating.
Hopefully, that means we get to pick up some stocks at a bargain soon!
Good Hunting Ladies and Gentlemen!
And don’t let your biases bite.