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Investing Specialists

Eight Mental Traps to Avoid

Investing is as much an exercise in controlling emotions as harnessing the intellect.

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With inherent uncertainty and high stakes, investing is as much an exercise in controlling emotions as it is an intellectual exercise. We're only human, after all. To make better decisions, it makes perfect sense to try to identify our natural weaknesses and biases to attempt to correct them. As outlined in the August issue of Morningstar StockInvestor, below are some of the common mental anomalies relevant to investing that could inhibit rational decision-making.

Anchoring
Anchoring is the act of latching on to a given piece of information and using that as a point of reference for making decisions. Unfortunately, many investors anchor on things that are irrelevant to a business's value, such as their own personal cost basis in a given stock or the 52-week trading high. Rather, we should focus on the thing that matters the most, the estimated future cash flow of a company.

As an example, have you ever thought to yourself, "If I can only get back to break-even on this stock, then I will sell." If you have, then you have fallen victim to anchoring on a piece of irrelevant information. Our cost basis in a given stock has absolutely nothing to do with the estimated intrinsic value of a business, so we are wise to utterly ignore cost basis when making buy and sell decisions. The same goes for any piece of data that does not inform one regarding future cash flow and true value.

Anchoring can also apply to how we view the world, and we could anchor on old situations by not incorporating new information to update our mental maps. For instance,  Dell (DELL) was a dominant company with major competitive advantages for the better part of two decades. But those advantages reached the end of the road. Those who saw this shift and acted appropriately fared much better than those of us (ahem) who had an outdated view of the company.

Availability Bias
This mental shortcut concerns the relative importance of information. The importance our minds attach to information is correlated to how often we see the information. If we see and think about something often, our brains attach greater importance to it.

By far the most easily available information in the market is stock prices. They're everywhere. But a stock's price is only one piece of the equation. Our goal as investors should simply be to buy things when the price is below intrinsic value and sell when the price is above intrinsic value. Knowing price without knowing value means you really don't know much at all. To help offset this bias, decrease the frequency you check the prices of your stocks, and increase the amount of time you spend reading things that contain really useful information, such as annual reports.

Endowment Effect
People place a higher value on things that they already own than things they do not own. Meaning, we would sell our possessions at a much higher price than at which we would buy the very same possessions if we did not already own them.

U.S. economist Richard Thaler pioneered a fascinating experiment with coffee mugs to illustrate this effect. Half of the people in a group are given coffee mugs and asked at what price they'd be willing to sell their mug. The other half are asked at which price they'd be willing to buy the same mugs. Inevitably, the sellers price the mugs at about double what the potential buyers do. We should ensure that we guard against falling into this trap with stocks, as it may cause us to hold on to a given position for too long. It may be helpful to pretend you don't already own something and then ask yourself, "Would I buy this stock today?" If the answer is "no" and a suitable replacement is available, it's probably worthwhile to make a trade.

Sunk Cost Aversion
Sunk costs are costs that cannot be recovered once incurred. Once something is paid for in either time or money, our instinct is that we must soldier on and get some benefit for the expense, lest we feel like we are wasting resources. This is a variation of loss aversion, which is a concept that says people feel the pain of a loss at double the magnitude they feel the pleasure of a gain of the same amount. Two tips here. First, if a stock is clearly worth far less than what we originally paid for it, we should be willing to sell if today's price is above our estimate of current value; that we are realizing a loss should be irrelevant to the decision. Second, if we spend several hours to research a given opportunity, we should still be willing to walk away. Our instinct will be to like the opportunity since we just spent time on it, but our goal should be to have rationality outweigh instinct.

Herd Behavior
Our deepest instincts tell us that there is safety in numbers. Beyond having a desire to do what is perceived to be socially acceptable, we often believe others have useful information from which we can take cues. After all, we all like to be liked, and the bigger group may know something we don't. Simply, if "everybody's doing it," we feel the pressure to take that same action, whatever it may be. Plus, with investing being an activity where having incomplete information is the norm, this instinct to take cues from others can be amplified.

This tendency can cause investors to chase whatever has outperformed in the past. This is also the instinct that is at the root of all bubbles and panics. Having an independent view and the willingness to go against the grain is not easy, but these are incredibly important actions to take if we are to have superior returns by buying low (when stocks are unpopular) and selling high (when the market is euphoric). As I've said before, buy on the cannons, sell on the trumpets.

 

Recency Bias
We live in the here and now, and the ability to contemplate things far in the past and/or future is a uniquely human ability that requires higher cognitive functions. Yet our instincts can still get the better of us on occasion. Recency is the tendency to weigh recent events much more heavily into our decision-making than more distant events. It is a sort of mental short-sightedness where we think much more about our current situation than the much broader historical perspective. This can cause us to assume that the current state of the world--good or bad--persists into the future, rather than reverting to a long-run mean.

There are a couple of different ways to overcome this. First, remember that the status quo in any given situation is not likely to persist. The world is constantly changing; don't just take the situation today and assume it will persist in perpetuity. Also, make sure not to just focus on a few years' worth of historical information, but look at data that extends further into the past. Think long and hard about whether something really is "different this time," or if mean-reversion is the most likely path.

I think this is one of the mental biases that we can easily exploit. By taking a long-term view in a world with an incredibly short-term focus created by short-term incentives, we can engage in "time horizon arbitrage" to create excess returns. As just a few examples, the market is assuming that the currently ugly situations in housing and employment are going to persist essentially forever, but I think the cycle will--eventually--turn back around. This is why I own  Home Depot (HD),  Lowe's (LOW),  Paychex (PAYX), and  ADP (ADP).

Confirmation Bias
Our brains inherently do not like conflict; they prefer to have a consistent, harmonious view of the world. They are wired to avoid cognitive dissonance--having two different ideas that are incompatible with each other. Our instinct is to search out information that confirms our existing views, accepting data that plug neatly into our preconceived biases, while rejecting data that do not support what we already think. Information that is consistent is processed more easily and does not increase stress.

Yet as with all these biases, this can be detrimental to us as investors, causing us to perhaps whistle past the proverbial graveyards, ignoring hazards and merely hoping for the best. As such, it's helpful to seek out views that actually oppose yours. Actively seek out the evidence that may disconfirm an idea. If you do this you will have a couple of benefits. One, you will not get too tied down to any one idea, maintaining better independent judgment; it will prevent "falling in love with a stock." Second, you will occasionally find that one of your investment theses is wrong. And if you are wrong, it's always good to discover a mistake earlier than later. Finally, if you can successfully rebut the opposing case for an investment, you will have more conviction when making trades and/or holding through market volatility.

Overconfidence
It's an unfortunate fact that people tend to believe that their skill level is much higher than what it is in reality. For instance, the vast majority of drivers believe their driving ability is above average, even though this is statistically impossible. Unfortunately, Lake Wobegon is but fiction, and there is not a place where "all the women are strong, all the men are good-looking, and all the children are above average."

This positive illusion we carry about ourselves allows us to be, as the famous book is titled, "Fooled by Randomness," and attribute positive outcomes to our personal skills rather than luck or a trend over which we really had no control. Overconfidence can help us get through the stresses of our lives, but it can be deadly in the world of finance by causing one to overplay his or her hand.

Overconfidence can also be caused by spending too much time on any given opportunity. There will be situations in the stock market where you will have all the information you need to make a decision very quickly. In this case, more information may increase your confidence to a dangerously high level, while not necessarily yielding a better decision. Consider how Warren Buffett operates; he can judge the durability of a business in a matter of minutes. He does not use spreadsheets with reams of data to make valuation judgments; he essentially does the math in his head. Of course, none of us has Buffett's skill level, but we can still learn from how he operates. Namely, it's much better to be approximately right than precisely wrong. We should also know that the future is inherently uncertain, and we will never be precisely right.

To guard against overconfidence, I think it is important to keep one's humility; we all know less than we think we do. Be willing to admit, openly discuss, and analyze mistakes. No investor has ever had anything close to a perfect record, nor do we need a perfect record to achieve good results.

But I think the most important thing to learn about overconfidence is that we should make sure not to take unreasonable risks. This means keeping an appropriate amount of diversification in a portfolio and not overbetting on any given idea. It also means having an appropriate margin of safety. Moreover, it may be helpful to have checklists and targets in writing for any given opportunity. Sometimes we are right for the wrong reasons, but our overconfidence will cause our minds to rewrite history. In the future, you can look at what was written to get a more honest assessment of what went right or wrong.

In this age of fair disclosure and a nearly ubiquitous Internet, it's almost impossible to gain an informational edge on the market. In other words, getting better results from investing isn't about seeking better information (which is virtually impossible), but rather looking at the available information more rationally. At Morningstar, how we've historically gained an edge is by having a superior perspective. Being aware of mental biases and inefficiencies is important if we wish to maintain this particular edge and continue to generate market-beating returns.

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Paul Larson has a position in the following securities mentioned above: DELL, HD, LOW, PAYX. Find out about Morningstar’s editorial policies.