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Human error: Investor psychology

Stephen Arnold, Head of International, Evans & Partners
April 2015

We are not the homogenous, rational participants envisaged by the creators of the efficient markets hypothesis. While we can’t 'unwire' our cognitive biases, we can make better investment decisions if we understand these behaviours.

In this paper we examine how our psychological biases can impede our ability to:

  • think independently - leading to dangerous crowd-following investment behaviour;
  • think flexibly - constraining our capacity to change our minds after making an investment;
  • think accurately – causing us to misinterpret the data that forms the basis of our investment decisions; and
  • think and act conservatively – causing us to overpay, overtrade, and take excessive investment risk.

We then look at techniques that we use to counter these biases and how we incorporate them into our investment process.

Independent thinking

We will make better investment decisions if we make them independently, as opposed to mimicking the actions of others. Asset markets are infamous for their destructive crowd behaviour, creating bubbles and crashes such as tulips in the 1630s, shares of Poseidon Mining in Australia in 1969, technology stocks in the late 1990s, and residential housing in America in the mid 2000s. We will avoid the wealth destruction that comes with bursting bubbles if we can stay outside the herd. However, our ability to make investment decisions independent of others is undermined by social proof, envy, and authority.

  • Social proof – the more uncertain we are, and the more stressful the conditions, the more we defer to the actions or judgement of others. For most participants, financial markets embody a great deal of both uncertainty and stress, and it is easy to assume that others have superior knowledge.
  • Envy – psychologists have demonstrated that most people measure their income and wealth in absolute terms and relative to their peers. Seeing your friends getting wealthier through riding a bull market makes you feel poorer. In order to have what they have, we will do what they have done and buy what they have bought.
  • Authority – the pressure to respectfully defer to an authority figure is immensely powerful. Market commentators, investment newsletters, and other market participants such as hedge funds are all seen as “experts” whose judgements or prognostications should be heeded - the financial market equivalent of a white coat. We take their authority at face value rather than first substantiating their role as expert through an examination of their track record and viewing it through the prism of their vested interests.

Flexible thinking

Once we have made an investment decision and acted on it our interests are best served if we maintain the flexibility to reverse course, perhaps in response to disconfirming evidence or a reassessment of the original thesis. However, our psychological biases make this very difficult. Changing one’s mind opens us up to uncomfortable cognitive dissonance. We use a variety of different psychological biases to preserve cognitive consistency – the consequence of which is denial, mental intransigence, and path dependency.

  • Confirmation bias – this is the tendency to seek out information that confirms our existing beliefs and to dismiss or favourably interpret information that contradicts or is inconsistent with them. In investing, the vast quantity of information that we are exposed to makes this is a powerful and dangerous effect - there is no shortage of economic, corporate, financial and political news that can be construed in a way that reinforces our belief in our existing investment positions.
  • Sunk-cost fallacy – the essence of the sunk cost fallacy is captured in the expression “throwing good money after bad”. It is a way of dealing with the cognitive dissonance that occurs when faced with evidence that contradicts a prior decision. A company CEO or government minister may justify continuing a failing project “because we have invested too much to quit now”. Instead of changing course we escalate our commitment as a way to affirm the wisdom of our original decision.
  • Endowment effect – we value things more highly once we own them. The fact that you own a stock doesn’t change what it is worth. By distorting our sense of value ownership can create inertia against rational action.
  • Regret aversion and status quo bias – a decision to do something imparts a higher degree of responsibility than decisions to do nothing. Therefore, we default to the status quo. Furthermore, the more choices we have the less likely we are to make one because we fear the regret of having made a sub-optimal choice. In an investment context we have many options yet choosing from them can feel burdensome. This can keep us from making sensible changes to a portfolio

This collection of heuristics act, often in interrelated ways, to constrain our mental flexibility. They limit our ability to identify an investment mistake when we have made one, and to take corrective action when one has been identified.

Accurate thinking

The informal rules and mental short cuts we employ to help us process information frequently lead us to draw erroneous conclusions.

  • Availability bias – we overweight the importance of recent or easily recalled information. In investing our expectations of future returns are highly correlated with recent experience, and the perceived likelihood of asset price bubbles, crashes, and recessions is heavily influenced by what has occurred recently. Availability and bias also often causes investors to overreact to company earnings announcements.
  • Incremental information – we overweight the value of additional information. In our data-rich world the desire of investors for more and more information is easily satisfied, but often it creates a false sense of “edge” and insight.
  • Representativeness – our natural inclination is to believe that causes resemble their effects i.e. big effects should have big causes, and complex effects should have complex causes. The non-linearity between cause and effect is sometimes called “the butterfly effect”. People look for large causes to explain significant moves in the stock market, major changes in an economy, or large deviations from normal in the operating performance of a company, often leading to a misinterpretation of events.
  • Sample size bias - people naturally believe that the behaviour of a small sample will be representative of the large population from which it is drawn. When investing analysts often make excessive adjustments to their long term earnings expectations of a company from financial results that cover short time periods.
  • Randomness – people chronically misconstrue random events, and have faulty intuitions about what chance sequences look like. Chance is mistakenly viewed as self-correcting, demonstrated at casino tables every day when gamblers say they are “due” some winnings after experiencing a bad run. Human nature abhors a lack of predictability and the absence of meaning, leading to a natural tendency to see order and patterns. We strive to achieve a coherent interpretation of events, and this leads us to imagined cause-effect relationships.

These cognitive biases suggest that the amount and immediacy of information available to investors today may be more of a curse than a blessing - worse than adding no value, it may detract from the accuracy of our thinking.  Likewise, our tendency to over interpret small amounts of data and draw erroneous cause-effect linkages may lead us to misdiagnose events and impair our understanding of what is hapening.

Risk-seeking behaviour

Investors have a bias towards taking risk due to a combination of overconfidence in their own ability; an over-optimistic assessment of the future; and an aversion to recognising and realising a loss.

  • Overconfidence bias – overconfidence is human nature, not simply the preserve of teenage males. In investing overconfidence causes us to underestimate risk and overestimate our edge, which may lead to excessive trading and risk taking.
  • Optimism bias –Optimism bias in investors is borne out in inflated expectations for equity returns and earnings growth. In a McKinsey study of five year EPS forecasts for US companies over the period 1985-99 expected growth was 12% pa, almost double the 7% pa rate actually achieved. Furthermore, consensus forecasts for earnings growth are almost never negative, whereas corporate profitability on average declines every three years.
  • Loss aversion – this refers to the asymmetry in the way people treat losses and gains. Psychologists estimate that people feel the pain of a loss 2 to 2.5x as strongly as they do the pleasure from a gain of the same magnitude. As a consequence we are willing to take more risk if it means the possibility of avoiding a sure loss and be more conservative given the opportunity to lock in a sure gain.
  • Self-attribution bias – we attribute successes to our own ability while losses are counted as “near wins” or bad luck or explained away by other external factors. Favourable self-attribution hinders our ability to learn from our mistakes and perpetuates the effect of the above biases on our appetite for risk.

Our hardwired tendencies towards overconfidence and optimism lead us to over-pay and over-trade. The feedback mechanism through which we would otherwise learn to counter these biases is weakened by self-attribution bias.

Investor myopia

For some reason most people are content not to have a daily valuation of their residential property but love to see daily prices of their share portfolio - and they can. However, the greater the frequency with which we observe investment returns the less information we see but the more discomfort we inflict on ourselves. To illustrate, assume an expected annual return from equities of 10% and an expected volatility of 13%, we can be 80% confident of a result greater than zero over one year. If we look at our returns every day we can expect to have 138 pleasant investment experiences and 122 unpleasant ones over a one year period. However, loss aversion tells us that the down days will produce far greater pain than the pleasure we derive from the daily gains of roughly the same magnitude. So we can turn a good annual outcome into a miserable experience through the high frequency with which we observe our returns. This creates stress, as a consequence of which we may sell shares after a period of declines, or avoid equities altogether to the detriment of our long term returns1.

Techniques that we use for managing biases

Over the last decade or so there has been a growing awareness of the role played by cognitive biases in investment markets. However, there is no evidence that this has being matched by an improvement in the quality of investment decision making, as demonstrated by the bubbles and crashes in credit markets, US residential property, and some emerging equity markets over the last seven years. As an investor an awareness of behavioural biases is not enough – you need to have tools to counter them and as much as possible codify these tools into your process. Below we discuss some approaches we find useful and the ways we formalise them into our investment process.

More independent thinking
  • Mindset – it certainly helps to be “wired” as a contrarian or someone who doesn’t need the constant comfort and reassurance of being with the crowd. Be wary of listening to financial market commentators – if you must, do so with a sceptical filter – and beware of popular investment themes.
  • Objective valuation – having a valuation approach tied to a variable such as the market aggregate or interest rates is a sure way to surrender independence of thought. We have an absolute valuation for each stock that doesn’t rise or fall with movements in the broader market.
More flexible thinking
  • Delay commitment – don’t rush to a point of view. There is value in being in “neutral” because it minimises path-dependency and commitment bias. We will generally follow a company for at least a year prior to making an investment.
  • Multiple scenarios – before you are emotionally invested in a position map out a range of possible outcomes and the milestones along the way you will view as confirming or disconfirming evidence. This gives you valuable emotional cover and helps to avoid commitment bias.
  • Seek out disconfirming evidence – we actively seek data that may falsify our investment thesis, and reduce the weight in our managed portfolios of a stock when the data is not supportive of our hypothesis.
  • Mental agility – John Maynard Keynes famously said “when the facts change, I change my mind. What do you do, sir?” We try to have an investment culture that puts a premium on mental flexibility.
  • Think in reverse – we counter confirmation and status quo bias by trying to disprove our hypothesis.
  • Investment alternatives – having a “cab rank” of stocks which you are happy to buy makes it far easier to sell a stock than if you have no ready alternatives. We maintain an “A-list” of 25 portfolio candidates on which we have completed due diligence and have a clear, objective valuation.

We know that not every investment will work out as anticipated. Having a flexible mindset and an appetite for disconfirming evidence helps us to minimise the cost of investment mistakes.

More accurate thinking
  • Checklists – checklists help reduce to human errors that arise from forgetting steps due to stress, familiarity and repetition. We use a pre-decision checklist in our investment process to ensure that proper due diligence has been completed and the portfolio candidate satisfies our demanding investment criteria. We also use a checklist when dealing with a negative event, such as a profit warning, to ensure we analyse the situation objectively and thoroughly.
  • Quality and quantity of information – one needs to think carefully whether an additional piece of information will improve our understanding of a situation, perhaps by mitigating sample size bias, or add only to our confidence.
  • Randomness – having a basic familiarity with the principles of randomness can help us avoid seeing false patterns and illusory cause-and-effect relationships.
  • Probability – having a basic understanding of probability theory gives us a greater awareness of low-probability events, and helps us to think in terms of a range of possibilities rather than in absolutes.
More risk-aware behaviour
  • Take out forecast risk – valuing a business on forward earnings “hardwires” optimism bias into the valuation process. The discounted cash flow approach is the ultimate expression of this. To mitigate optimism bias we value businesses by applying a multiple to trailing, not prospective earnings.
  • Manage position size – it is natural when making a new investment to focus on the company’s wonderful attributes and only become more aware of its inevitable challenges or shortcomings over time. We attempt to compensate for overconfidence by introducing a new position with a below-average weight and then scaling up over time.
  • Distinguish between risk and consequence – if the consequence is unacceptable then the risk, however small, is too.
  • Dangerous combinations – we pay special attention to ways in which different risks can combine to create toxic effects. Adding debt will amplify whatever operational risks a business faces. We have an aversion to financial risks, only owning companies with strong balance sheets and avoiding inherently geared businesses such as banks.


We have shown that natural human psychological biases can undermine sound investment decision making. Heuristics impede our ability to think and act independently; make it difficult for us to accurately and objectively interpret the information we use to form an investment decision; create enormous barriers to changing course once a decision has been made; and generate an excessive appetite for risk. A measure of the cost to investors these biases extract is the 'investor behaviour penalty', which shows investors in US equity funds achieved returns less than half that of the average equity fund over the last two decades.

Achieving good investment results requires both a sound process, and disciplined application of that process through well-reasoned judgements. Investor psychology is where what you say becomes what you do; it is how the rubber meets the road. It is why different investors who say the same thing do very different things, respond to the same news and events differently, and achieve very different results.

In applying our investment approach we have an acute awareness of our natural biases and the dangers they pose, and we hardwire into our process measures to counter them. We know the foundation for investment success is the mistakes you don’t make, so we strive for conservatism, independence, and mental agility.


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