Stock picking is a difficult endeavor and has been even more so over the last few years as investor panic over the financial crisis and recession increased market volatility. Investors can improve their prowess in the stock market by understanding various cognitive and behavioral biases that lead investors to make poor decisions on whether to buy or sell stocks.
These biases are difficult to recognize, usually operate unconsciously and are difficult to stop even when recognized. Here are four common biases that just might hurt you as an investor.
TUTORIAL: Behavioral Finance: Introduction
Confirmation bias refers to the tendency of individuals to give greater weight to information that confirms or reinforces an existing belief or hypothesis. Evidence that contradicts this belief is discounted and given less credence. This selectivity in weighing evidence is done unconsciously by individuals and leads to incorrect decisions in the investing world. The best method of countering this bias is to look for evidence that your thesis is wrong and challenge that belief on a regular basis.
An offshoot of confirmation bias is commitment bias, which is the tendency of individuals to increase belief in an investment thesis once that position is expressed in public. Disconfirming evidence is ignored as the investor must defend his or her statements or lose face. Are you one of those investors that spends hours making posts on investment boards supporting a stock, only to see the stock plunge 20% one morning? After that, instead of rationally examining new information on the stock, do you spend even more time coming up with some tortuous explanation for why the stock is still a buy?
On the sell side this is manifested in the "no new news" report issued after a company screws up and gets hammered by the market. In this type of report, the analyst vociferously defends his thesis and "pounds the table" on the stock. (For related reading, see 5 Mental Mistakes That Affect Stock Analysts.)
Social proof or informational social influence is another vicious problem in the investment world and operates when an investor is unsure what course of action to pursue on a stock and looks at the actions and behavior of others to decide what to do. Dr. Robert Cialdini has written extensively on this subject and summed up social proof as viewing "a behavior as more correct in a given situation to the degree that we see others performing it."
There are certain conditions that tend to aggravate this bias in the investment world. These include a crisis situation where an investor has little time to make a decision in an environment that is rife with so called experts. Another condition that acts as an accelerant to this bias is the extent of the similarity of the group involved in the decision. When everyone looks and acts the same, social proof is aggravated. This explains why professional investors are also impacted by this bias as anyone who has worked in the industry can attest to the similarity of the institutional investment community (usually male, Caucasian, wearing suits, attended the same top colleges and hold CFAs, etc.). These three factors seem to be a fairly accurate description of what an investor confronts in the stock market and provides the psychological explanation behind the herd mentality that is so prevalent in the market.
Information cascades is related to social proof and is defined as making a decision after observing the behavior of others while ignoring internal information signals that contradict that action.
This type of behavior has been observed in many areas of finance including corporate takeovers, initial public offerings, bank runs and debt restructurings. An investor that becomes envious of others making money in an asset bubble and jumps in, while ignoring his gut instinct that says not to invest, has become a victim of this bias. (Find out the strategies corporations use to protect themselves from unwanted acquisitions. For more, see Corporate Takeover Defense: A Shareholder's Perspective.)
The Bottom Line
Investors are supposed to be rational and the stock market is supposed to be efficient but we all know what nonsense that is. An individual that understands and avoids the common behavioral issues that impact decision making will be a better investor in the long run.