By Noah Solomon

Special to the Financial Independence Hub

Behavioural finance is the study of the influence of psychology on the behaviour of investors. Its central theme is that investors are not always rational, have limits to their self-control, and are influenced by cognitive biases. People harbour a multitude of self-defeating behaviours that lead to self-defeating results.

In The Laws of Wealth: Psychology and the Secret to Investing Success, author Daniel Crosby states: “The fact that people are fallible is your biggest enduring advantage in the accumulation of greater wealth. The fact that you are just as fallible is the biggest impediment to that very same goal.”

Confirmation Bias: Letting the Tail wag the Dog

Confirmation bias is the tendency of people to pay close attention to information that confirms their beliefs and ignore information that contradicts it.

Most of us have a really bad habit of only paying attention to information that agrees with our existing beliefs. Our natural tendency is to listen to people who agree with us because it feels good to hear our opinions reflected to us. We also tend to let the proverbial tail wag the dog: to draw conclusions before objectively weighing the facts. We first construct hypotheses, and then subsequently look for information that supports them.

Even some of the greatest investors have fallen prey to the confirmation bias trap. In December 2012, Bill Ackman, Chief Investment Officer of Pershing Square, launched a crusade against Herbalife, a nutritional supplements company, referring to the company as a pyramid scheme and stating that its stock was worthless. After taking a $1 billion short position in Herbalife, he continued to seek supporting evidence for his original hypothesis from Herbalife customers who had poor experiences with the company.

Activist investor Carl Icahn, who had an opposing view, acquired a 26% ownership stake in the company. The epic battle that ensued between two of Wall Street’s biggest titans resulted in a major loss for Ackman. Had Ackman attempted to find potential flaws in his thesis by seeking out customers who had positive Herbalife experiences, he might have either avoided or mitigated the losses which his fund suffered.

Loss Aversion/Disposition Effect: The Pain of Losses is (Myopically) larger than the Pleasure of Gains

Loss aversion does not describe the tendency of people to try and avoid losses, which is completely rational. Rather, it refers to having an economically unbalanced desire to avoid losses at the expense of foregoing commensurate or greater gains, which can cause them to win battles yet lose wars.

Loss aversion can cause investors to refrain from selling losing positions in the hope of making their money back, thereby allowing run of the mill losses to metastasise into “there goes my house” losses.  Loss aversion can also lead to significant opportunity costs, as money gets “trapped” in underperforming investments at the expense of foregoing better opportunities.

Closely related to loss aversion is the disposition effect, which refers to a cognitive bias that causes investors to sell winning positions prematurely and irrationally stick with losing positions. When a position is rising, we get anxious to lock in our gains and sell prematurely. At the same time, people are often too slow to cut their losses on holdings which are losing money and hold on to them in the hopes that they will recover. These behaviours tend to diminish gains and exaggerate losses, thereby leading to poor overall performance.

Fear of Missing Out: There’s nothing more annoying than watching your neighbour get rich

Fear of Missing Out (FOMO) refers to feelings of anxiety or insecurity over the possibility of missing out on an event or opportunity. What is most interesting is that FOMO is an emotional reaction that pushes us to trade or invest in a less disciplined way. Rather than buy stocks when they offer the most attractive risk-to-return ratio, investors are driven to buy them to an even greater degree the less attractive they look technically. Our fear of missing out becomes greater the more the market continues to act in an irrational way.

FOMO is frustrating because it occurs when the market is doing the unexpected and we are sticking to a solid plan. From 1996 to 2000, the NASDAQ stock index exploded from 1,058 to 4,131 points. Many of these technology stocks had little or no earnings yet still commanded steep prices. Investors feared that if they didn’t get in now they would miss out. Millionaires were minted overnight until it all went wrong. The dotcom bubble burst, and trillions of dollars of investor wealth vanished as the NASDAQ plunged to under 2,000 points by the end of 2001. Few did their due diligence on these hot tech stocks to make sure they were the best long-term investments for their personal portfolio and goals. It took many years for the average investor to recover.

In his characteristically folksy yet caustic manner, Warren Buffett used the following analogy to illustrate the absurdity of FOMO:

“Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem: They are dancing in a room in which the clocks have no hands.”

The Bandwagon Effect: Making sheep look like independent thinkers

The bandwagon effect describes the tendency of investors to gain comfort doing something simply because many other people are doing it. The tendency of people to prefer doing ill-advised things that others are doing rather than act rationally in isolation is best summarized by John Maynard Keynes:

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Whereas using the performance of others as a reference point for measuring your results mitigates the risk of underperforming your peers, it can expose you to severe losses. The widespread abandonment of reason and rationality associated with a herd mentality has historically resulted in speculative bubbles in which the crowd joins hands and runs off the cliff together. Continue Reading…