Investors deal with facts and emotions.
We may profit from the investors' irrational behaviour by understanding the cognitive biases investors have.
#1 Loss-Aversion bias
- People tend to strongly prefer avoiding losses as opposed to achieving gains.
- Usually, the investor holds on to the losers until they break even, while selling the winners to realize gains and avoid further risks.
“The idea of excessive diversification is madness. We don’t believe that widespread diversification will yield a good result. We believe almost all good investments will involve relatively low diversification. If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity but a hell of a lot of patience. You stuck to your principles, and when opportunities came along, you pounced on them with vigor. Berkshire in its history has made money betting on sure things.” Charlie Munger
#2 Overconfidence bias
- People demonstrate faith in their own intuitive reasoning, judgments and/or cognitive abilities. This may result in overestimating knowledge levels, abilities and access to information.
- We do this when we equate the quantity of information with its quality, which causes underestimation of risks and overestimation of expected returns.
“It is not an algorithm. It is a mindset. I think that we always try to stress the danger of overconfidence. I forget if I put it in the book, but it is better if you invest scared, if you worry about losing money, if you worry about being wrong, if you worry about being overconfident because these are the things you want to avoid. They should be foremost in your mind. The most dangerous thing is to think you got it figured out, or that you can’t make a mistake, or that your estimates are right because they are yours. You have to always recheck your information, bounce your ideas off of yourself and others.” Howard Marks
#3 Self-control bias
- People fail to act in pursuit of their long-term goals because of a lack of self-discipline.
- Fail to save for retirement, prefer small payoffs now than large payoffs in the future. Spend today rather than save tomorrow.
“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day – if you live long enough – most people get what they deserve.” Charlie Munger
#4 Status Quo bias
- People usually let the standard choices be the ones that rule our operations. Prefer things as they are even at a personal cost.
- Fail to explore other opportunities, leave portfolios as they are instead of looking for more attractive investment options.
"I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action." Warren Buffett
#5 Endowment bias (Excessive Self-Regard)
- People assign more value to an asset when they hold rights to it.
“We all commonly observe the excess self-regard of man. He mostly misappraises himself on the high side.” Charlie Munger
#6 Regret-Aversion bias
- People tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly.
- No action becomes the preferred decision. This happens when we take a very conservative stance fearing poor outcomes, or when we just follow the herd.
“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it - even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” Benjamin Graham
References:-
