BT INVEST

A Personal Finance and Investment Arm of The Business Times
MARKET TODAY:

Archive

Biases in Investing

By Ernest Lim

Biases in Investing

"I'm an idiot. I shouldn’t have sold off 'Stock A'. I just know that it will rocket upwards in the next few days. And now it has surged. It is so obvious. I should have seen it coming"

Do the above sentences sound familiar? If yes, then you probably have a hindsight bias. Biases are typically insidious and can affect and distort our thinking and interpretation of data and choices without our knowledge, thus we have to be wary of the biases and act accordingly. I was recently asked by Lianhe Zaobao (please refer to their article HERE dated 25 Sep 16) on some examples of biases seen in investing. Consequently, I have put together a write-up below and will seek to demystify the insidious biases which may cloud our judgment and affect our investment decisions.

1. Equity home bias

Definition: Equity home bias refers to the biased perspective which investors have in holding foreign equity which result in them holding modest amounts of foreign equity, despite the benefits from international diversification. I.e. retail investors in Singapore are more likely to hold Singapore listed shares then U.S. shares as they believe that they know the companies better.

Example: For me, I have this equity home bias. Rather, I believe that I should just analyse companies within my circle of competence and not analyse other overseas companies where I don’t have a competitive edge over other investors and traders. In addition, different countries present their financial statements differently so I prefer to use the time and effort on Singapore listed counters. Furthermore, I have limited access to the management and investor relation personnel of overseas listed companies as they are also located overseas. As of now, I believe there are still companies worthy of analysis on our Singapore Bourse.

Solution / how to avoid it: It is worthwhile for investors to consider the benefits from diversifying some of their holdings in foreign equity. They can consider to either invest in exchange traded funds which track an index or in unit trust specializing in foreign equities.

2. Confirmation bias

Definition: Confirmation bias is a tendency to focus on information that confirms one’s preconceptions, independently of whether they are correct.

Example: If I give the same analyst report on Stock A with a neutral call to two people, each with an opposite opinion, the investor who is bullish on Stock A is likely to more readily remember positive information in the analyst report which corroborates his bullish position. So does the investor who is bearish on stock A. He will likely remember information which supports his bearish position.

Besides selective collection of evidence, confirmation bias may set in during the interpretation of evidence. For example, if I believe the economy is likely to be strong for the next two years, I may interpret inventory surplus as a sign of robust outlook as producers stock up inventory for future demand. A person who believes that the economy is likely to remain weak will view the inventory surplus as lack of current demand which may spiral into price cuts and affect the company’s margins.

Solution / how to avoid it: Thus, to interpret the situation on inventory surplus, one has to take into consideration of a broad range of data to reach a conclusion, bearing in mind the presence of confirmation bias.

3. Hind sight bias

Definition: This refers to the predilection to exaggerate one’s ability to have foreseen the end result, after the outcome has happened. Simply put, this is the “I knew it all along” phenomenon.

Example: Oftentimes, investors would chide themselves that they should have held on to an investment longer, so that they can reap more gains. Or, they should have cut their losses upon seeing some red flags in the companies’ financial statements. Some of these “should have” may be genuine mistakes (which investors should learn), while others may not be that obvious at that point in time.

Solution / how to avoid it: It is important to be aware of the above bias and do not criticize yourself too harshly for uncontrollable events.

4. Status quo bias

Definition: Status quo bias is our inclination to prefer the current situation, as opposed to making a change. This is regardless of whether the current situation is optimal.

Example: An example of this is that there are still many investors who prefer to keep their excess funds in savings accounts or money funds. They are unwilling to allocate part of their excess funds to investments such as stocks and bonds as this would deviate from the status quo.

Besides the inertia to change which can manifest in the type of assets that you own, status quo bias can also appear in another situation. For example, security analysts may take a long time to amend their previous estimates and assumptions (as they don’t want to change) when new information should make them reanalyze the situation and prospects.

Solution / how to avoid it: Investors should constantly evaluate their existing investments as and when there is important information announced by the company so that they would not succumb to the status quo bias.

5. Availability bias

Definition: This refers to the events which are readily “available” in your memory which we will naturally presume that such events are commonplace.

Example: Vivid footages of airplane crashes are typically available in our memory and we may wrongfully think that airplane crashes are rather common. However, studies have shown that the chances of having an airplane accident are one in 11 million vis-à-vis one in 5000 for car crashes.

Similarly, some investors may have heard high profile accounting scandals of S chip companies such as Oriental Century, Ferrochina, China Sun Bio Chem etc. and they have sworn off investing in S chips as a whole.

Solution / how to avoid it: In my opinion, there is bound to be some black sheep now and then. It is not wise to ignore the S chip, or small cap universe as a whole as there are bound to be some good companies with upright management and sound business fundamentals, trading at attractive valuations. Notwithstanding this, I hasten to add that it is natural that small cap companies are typically more risky than blue chip companies. Thus, if one were to always invest in small cap companies (after doing extensive due diligence), it is still likely that he or she may buy into a company with possible accounting scandal.

6. Self-serving bias

Definition: Self-serving bias means that humans usually attribute their successes to internal or personal factors but attribute their failures to situational factors beyond their control.

Example: For example, if an investor invests in Stock A and it collapses the next day, he may attribute that to market manipulation or general market weakness which he cannot control. However, if it rallies 50% the next day, he would view himself as 股神 or (God of Stocks).

Solution / how to avoid it: The above bias is pretty destructive to investing as it shrinks responsibility when something goes wrong. For most of the investments which went wrong, I do believe that there may be some red flags which we have overlooked in our investment due diligence and we should take responsibility and learn from them.

Conclusion

In the investment arena, we have many variables to contend with. Some of them are controllable like our emotions, our biases, the amount of hard work that we put in etc. Some of them are uncontrollable, like how the market will move in the next 30 minutes, or whether there is another terrorist attack such as the one seen on 9/11. In order to increase the probability of investing in a profitable investment, we should control those controllable variables. Knowing the biases and how they manifest in investment decisions, and most important of all, make a conscious effort to prevent most of these biases would substantially increase the odds in profiting from investments over time. To draw a quote from Sun Tzu, Art of War, “to secure ourselves (“our biases”) against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself (“the market”)”.

Disclaimer
Please refer to the disclaimer here

 
Ernest Lim
Ernest Lim

Ernest is an avid investor, trader cum remisier. He is a Chartered Financial Analyst® charterholder, as well as, a Chartered Accountant of Singapore. He has published articles on a wide range of topics on finance and investment on his blog http://ernest15percent.com/, ranging from market / sector outlook, technical analysis and fundamental analysis etc. His writeups and comments have been featured in various online and mainstream media such as Bloomberg, Business Times, Lianhe Zaobao, Sharesinvestment, Nextinsight etc.

He has worked at GIC Special Investment and was with Legacy Capital Group Pte Ltd, a boutique asset management and private equity firm, as an investment manager for high net worth clients, after which he went to work as an investment manager before embracing his lifelong passion as a remisier.