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Stop Playing Investment Mind Games


How Behavioral Biases Affect Your Investing Returns


I have been involved with investments directly or indirectly for over 18 years. During this time, I have had many successes, but also many failures. Looking back with hindsight, I can say that many of my failed investments, or investment recommendations, were due to various behavioral “biases”, which unbeknownst to me at the time, negatively impacted my ability to properly analyze, recommend, invest, or in some cases change my views of a company or its stock. The study of behavioral biases in investing has significantly increased over the past few decades, as universities, business schools, and investment firms have tried to find ways to remove these biases from their students or investment professionals. We hope investors can gain insight into biases that may be affecting their own investment decisions and improve their individual investment process to achieve better long-term investment returns.


While there are multiple biases that can arise from decisions relating to investing, we have chosen to focus on four common biases: 1) Over optimism/confidence, 2) Over reliance on forecasts/price targets 3) Confirmation bias, and 4) Hanging onto views – PermaBull/PermaBear bias. I have seen these behavioral patterns negatively impact not only my historical investment decisions over periods of my career as a professional investor, but many individual investors as well. We believe by understanding Behavioral Finance, and the negative impact these common biases can have on achieving your investment goals, both professional and individual investors can improve the process they apply in making investment decisions.


Behavioral Finance, as defined by Webster’s Dictionary, is “the behavior relating to or concerned with the social, psychological, and emotional factors that affect financial decisions and behavior.” The study of Behavioral Finance began by some accounts in the early 1980s, but many individuals, including successful investors such as Ray Dalio or Warren Buffet, have been implementing its theoretical practice for decades. A key concept in Behavioral Finance is that individuals can identify flaws in their decision-making process which will allow for better decisions in the future. By understanding common investment pitfalls and challenges related to Behavioral Finance you may be able be able to refine your investment process. Improvements in future investment decisions are often derived from the refinement of the process by which we invest. Your individual process to how you invest is the only element of control one may have in the uncertain world of investing.


Bias #1: Over confidence/optimism. Wall Street is full of professionals who believe they have an edge, or superior information over all other participants. As an analyst you must constantly exude confidence in your recommendations, or else have investment professionals utilizing your research question the conviction in your thesis. A great book for investors to read regarding Behavioral Finance, which illustrates how little conviction or confidence relates to profitable investment decisions, is “The Little Book of Behavioral Investing: How to not be your own worst enemy” by James Montier. In the book the author discusses a group sample of more than 600 professional fund managers who were asked how many of them believed they were above average at their jobs. An astonishing 74 percent responded that they believed their ability was above average. In a similar study 70 percent of analysts believed they were better than peers at forecasting. However, the same analysts in the study had 91 percent of their recommendations as either buys or holds in February 2008, suggesting limited difference in their forecasting abilities. I believe both studies demonstrate the prevalence of over confidence that many Wall Street professionals believe they have. In other words, somehow each individual believes they have better control over outcomes than others engaged in the same profession.


Another study referenced in the book by G. Torngren and H. Montgomery(1), highlighted the outcomes between a group of professional investors and psychology students. Each participant in the study selected a stock from a pair of blue-chip companies and determined which of the two stocks presented was likely to outperform each month. The study noted that the psychology students were around 59 percent confident in their stock picking skills, while professionals were on average around 65 percent confident. Over the course of the study students picked the right stock 49 percent of the time, while professionals only achieved accuracy of 40 percent. Furthermore, the study noted the potential pitfalls related to over confidence/optimism. At times, during the study, the investment professionals were asked to provide their confidence levels in their stock picks, when these professionals were 100 percent confident, they were correct less than 12 percent of the time. Ironically within this study the psychology students noted that guessing was their primary input in their investment decisions, while professionals noted “other knowledge” as key in their decision process.


Over optimism/confidence is a key behavioral trait that both professional and individual investors must overcome to improve their investment process, and thus hopefully improve their investment outcomes.


Bias #2: Over reliance on Forecasts/Price Targets. Quotes from the two leading figures of Berkshire Hathaway, one of the most successful investment firms in modern history, offers great insight into the pitfalls related to over-reliance by investors on future forecasts or analyst price targets. According to Charlie Munger, Vice Chairman of Berkshire Hathaway, “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something.” The founder of Berkshire Hathaway, Warren Buffet, once stated “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Another interesting fact related to analyst’s ability to accurately forecast future earnings noted in “The Little Book of Behavioral Investing: How to not be your own worst enemy” by James Montier, states “When an analyst first makes a forecast for a company’s earnings two years prior to the actual event, they are on average wrong by a staggering 94 percent. Even at the 12-month time horizon, they are wrong by around 45 percent!”


Forecasting has become a mechanism by which investors are provided a baseline estimate for how a business may perform in future periods, and whether a stock may be overvalued or undervalued relative to those forecasts. However quite often, as noted in the quote above, these forecasts can be revised suggesting the value assigned to a stock, or company 12 months prior, may not offer any real insight into what the actual value is today. Other than forming a consensus opinion from which to utilize in our investment process, estimate forecasts, or even more so analyst price targets, are not something that should be heavily relied upon as a basis for investment.


In the book “The Little Book of Behavioral Investing: How to not be your own worst enemy” by James Montier, the author noted a study performed by Phillip Tetlock(2) regarding forecasters, and what was the reasoning that their prior forecasts were wrong. The author notes that instead of any self-insight or post mortem analysis, forecasters used roughly five common excuses for why things didn’t play out as expected. The first was titled the “if only” defense – as an example, if only the Federal Reserve had raised rates, then the prediction would have been true. Next was labeled the “ceteris paribus” defense – something outside of the model of analysis occurred, which invalidated the forecast, therefore it wasn’t the forecasters fault. The “I was almost right” defense – although the predicted outcome didn’t occur, it almost did. Or there was the “it just hasn’t happened yet” defense – I wasn’t wrong, it just hasn’t occurred yet. Finally, the “single prediction” defense – you can’t judge me by the performance of a single forecast. While reading all these excuses, I couldn’t help but chuckle, knowing full well that as a former forecaster, or better known as a Wall Street Analyst, I had also made similar statements when investment predictions I made didn’t come to pass.


Over reliance on analyst price targets is something I see time and time again when I listen to investors discuss investment mistakes. Statements such as “analysts stated shares should be valued at X thus there was no way that shares should now be trading at value Y.” All too often investors don’t take time to review their investment process and why they are investing in a company or business, instead they simply rely on forecasts and price targets of analysts assuming this alone is a solid basis for their investment dollars.


A great example of why analyst price targets may be a false predictive is evident in the Biotech Investment Strategy we are currently constructing at Grinder Capital. Many of the companies we are tracking for inclusion in the strategy are small capitalized pre-clinical companies developing new drugs or treatments that one day may yield significantly higher value than what is implied in their price today. The average stock price of the roughly 60 companies that we track is about $16, with many shares trading below $10 and $5. However, the average price target upside, based on current analyst forecasts suggests potential upside of about 161 percent.


If an investor were to heavily rely on future forecasts of the analysts covering these companies, and their respective price target, one should simply buy shares in each company and expect over time significant upside to relative share prices. However, investing in biotech companies requires significantly more research than simply focusing on future upside in the target prices provided. Often, companies with expectations for future success see treatments or drugs fail in early trials, or the long-term success estimated in analyst forecasts doesn’t come to fruition due to competitive alternatives or other outside factors. Instead of focusing on price targets, or even the treatments or drugs themselves, which often highly trained medical professionals are unable to forecast accurately, we believe investors should look to buy a basket of companies trading near low valuations, with expectations that some will likely see higher valuations than today, and those that don’t, have less downside than the risk associated with much higher priced alternatives. Basing your investment process on future expectations, or future price targets, is a common pitfall that has negatively impacted future investment returns for both professional and individual investors.


In avoiding over-reliance on forecasts, and price targets, and recognizing they serve only as a potential baseline or part of your total investment process, we believe investors will be able to fine tune their investment process to achieve better future investment returns.


Bias #3: Confirmation Bias. All too often we feel more confident regarding a potential investment when we read comments by experts or other investors which validate, or confirm, our hypothesis and reasoning for investing in a company or stock. Professional investors often engage in confirmation bias by huddling together as a group and discussing what the company’s management stated in recent meetings and how those statements confirm their views on why the stock may be undervalued or overvalued. Individual investors often watch financial news networks, read investment blogs, or investor message boards, looking for individuals who lay out the same hypothesis they have regarding shares and thus validating their basis for investment.


According to the principles of Behavioral Finance investors should spend almost zero time in their investment process looking for confirmation of their thesis, but instead focus on disproving their thesis and understanding what in their views could be wrong and cause an alternative outcome to the one they believe is most certain. As noted in the “The Little Book of Behavioral Investing: How to not be your own worst enemy” by James Montier, investors are twice as likely to look for information that agrees with our thesis than we are to seek out disconfirming evidence. Confirmation bias can enhance potential negative effects of prior discussed biases such as over confidence/optimism as we tend to believe the more “facts” we read and review, which often agree or relate to our view of the investment thesis, causes higher levels of conviction. This can lead to investors buying outsized positions in securities or taking on excessive risk, as they believe the facts they have reviewed, which often simply validate their view, suggest an even higher level of conviction in any company or stock is justified or warranted.


When developing an investment process, investors should focus equal amount of time to both what can go correct in their investment thesis, and what may go wrong. All too often investors focus heavily on the outcome, which is typically inline with their views, instead of focusing on the process, which can help to remove the negative effects of confirmation bias and enhance future investment returns.


Bias #4: Hanging on to Views – PermaBull/PermaBear. The stock market is a dynamic marketplace, in which opinions or perceptions of a company, or its stock price, can change day to day. All too often I have seen individual and professional investors, myself included, who have become “married” to a view regarding a company or its stock. This PermaBull or PermaBear phenomenon as it is described on Wall Street is a common pitfall of investing. As a German proverb once stated “trees don’t grow to the sky” but by the same token a stock may not continue to see sustained declines over the longer-term. A common pitfall of investors is hanging on to a thesis, being dogmatic that their view regarding a company or its stock, whether it be bullish or bearish, is the only likely outcome.


The psychological challenge for many investors, even professional investors, in continuing to hang on to their view of a company or its stock is the fact that changing our views will require us to acknowledge that prior views may have been incorrect. This is a difficult issue to accept, especially if it requires the investor to accept taking a loss on their investment, or professional investors such as research analysts, recognizing the prior recommendation was incorrect. Accepting a loss is definitive, and thus difficult to accept versus the optimism that the stock’s value may appreciate in the future, but over confidence/optimism that a stock may rebound often leads investors to hold onto losers longer than may have warranted.


An issue that may lead investors to hang onto views longer than they should typically occurs due to belief in a “story.” A “story” is typically the narrative provided by individuals or professionals as why a stock may continue to make new highs even after a significant appreciation in value or continue to decline following a recent sell-off. These stories provide a narrative which can often dictate how we view an investment. However, more often than not, these “stories” tie-in with other potential biases such as over confidence/optimism, reliance on forecasts, or estimated valuations.


A sound investment process can help investors avoid bias from hanging on to losing investments longer than necessary. Investors should incorporate a thesis for why they are buying a stock within their investment process. This thesis should be constantly tested to make sure it remains valid. Investors must be willing to realize that no investment process or strategy is perfect, and there will be investments that generate losses. However, by focusing on an investment process, investors may be better positioned to avoid biases which may negatively impact their long-term returns.

On Wall Street, the “facts” or “stories” regarding a company or its stock can see dramatic swings. Stocks that were once darlings of investors, and went up day after day, can see precipitous declines, while stocks which many investors believed no longer had sustainable long-term value can sees significant appreciation as the perception regarding the company changes. To avoid the trappings of hanging onto views or PermaBull/PermaBear bias investors must be willing to change their mind as the facts change.


In summary, investors face a myriad of pitfalls while attempting to achieve their long-term investment goals. Avoiding common behavioral biases or learning to better identify them in your own investment process, can offer a way to enhance returns and potentially limit losses. The utilization of a well-defined process provides a repeatable mechanism for identifying potential investments. A good investment process should begin with a thesis for owning a company’s stock. The investor’s thesis should be regularly tested, without the influence of confirmation bias. The investment process should not be reliant on future forecasted earnings, or analyst price targets. These factors should be considered in the investment process, but only as part of the overall thesis, not the determining factor. Investors must trust the investment process, and not change the process when things may not work in the short-term. However, if changes to the original thesis occur, investors must be willing to change their view, even accept an investment loss, as the facts change to avoid bias. By focusing on process, and not potential outcomes, investors are better prepared to reduce the influence from behavioral bias in their investment decisions.


Sources:

Montier, James. The Little Book of Behavioral Investing: How to not be your own worst enemy. Hoboken, New Jersey. James Wiley & Sons, 2010. Print.

1 – G. Torngren and H. Montgomery, “Worse Than Chance? Performance and Confidence among professionals and Laypeople in the Stock Market,” Journal of Behavioral Finance 5 (2004): 3.

2- Philip Tetlock, “Theory-Driven Reasoning about Plausible Pasts and Probable Futures in World Politics,” in Heuristics and Biases: The Psychology of Intuitive Judgement, ed. T. Gilovich, D. Griffen, and D. Kahneman (Cambridge University Press, 2003).

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