March 28, 2024
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6 Biases of Investing to Avoid Now

Most people and professionally managed funds fail to beat the market. Between 1999 and 2018, the average investor had an annualized return of 1.9% while the S&P 500 returned 5.6%. Why? Because humans are prone to make bad decisions, and fall victim to biases or mental shortcuts when it comes to investing. Here are 6 mental mistakes that cause us as humans to fail to beat the stock market (i.e. S&P 500 index).

Contents

Availability Heuristic

Availability Heuristic is a common mental shortcut we take before making a decision. We may believe that just because some event or data can easily recalled, it should be given a disproportionately large weight for your decision-making.

Example: You may have read in the news how profitable Dogecoin was. It rallied 400% in a matter of days. Dogecoin quickly made people millionaires.

Google search result for Dogecoin 400%
Google Search Result

Why you need to be careful: Given all the information you saw, you may have thought that Dogecoin was a sure win. However, it is confirmed fact that Dogecoin is MUCH more volatile than the stock market. Dogecoin is currently not widely used or adopted. There is no cap in the amount of Dogecoin that could be produced.  Make sure you collect all of the facts before buying Dogecoin, rather than rely on readily available news stories that tout its success. 

Confirmation Bias

Confirmation Bias is the tendency to seek and interpret new evidence as confirmation of your existing beliefs or theories.

Example: Google is up 55% over the past year. Apple is up 87%. Microsoft is up 46%. This incorrectly confirms my belief that tech stocks are hot and I should invest more in tech stocks.

Why you need to be careful: Tech stocks have been hot in 2019 and 2020. This is fact. However, it is also fact that being hot one year does not guarantee being hot the next year. Of 12 sectors analyzed below, tech was the 3rd worst performing sector in 2008 and 2010. It was the 4th worst performing sector in 2012.

Table showing S&P 500 Sector Performance from 2007 to 2020
Source: Novel Investor

If jumping into hot sectors was the secret to success, we’d all be rich from Beanie Babies, Tickle Me Elmos, and Enron. Unfortunately, that’s not how it works, at least in the long term. 

Hindsight Bias

Hindsight Bias is the tendency for you to believe you could have predicted the past.

Example: I knew I should have sold all of my stock right before COVID hit!

Why you need to be careful: On 3/23/20, the S&P 500 hit a new local low of 2250. You may have thought, I knew I should have sold my stock on 2/20/20 when the S&P was at much higher at 3395. 

If you thought the sky would continue to fall on 2/20/20, and sold your stocks, you would have been in for a rude awakening. The stock market has more than recovered, and is at 3870 as of February 2021. That is a recovery of over 70% from the lows! Didn’t see that one coming did you?

S&P 500 chart from Apr 2019 to Feb 2021
Source: Barchart

If you could have predicted the past, you would have bought Google, Apple, and Bitcoin when they were all pennies on the dollar. Everything is crystal clear, but only in hindsight.

The Dunning-Kruger effect

The Dunning-Kruger effect is a bias that people with low ability incorrectly overestimate their abilities. It could be that they are too ignorant to correctly estimate their abilities or assess their level of knowledge.

Here is a hypothetical chart of confidence vs. knowledge in field that shows the Dunning-Kruger effect in full display.

https://thinkingoutcloudorg.files.wordpress.com/2020/05/dk-effect.png?w=718

Dunning-Kruger effect
Source: Thinking Out Cloud

When reading about this effect, I am reminded of my old self. When I was a teenager I thought I knew everything there was to know. I thought I was right and my mom was wrong. How surprised I was to find out later that my mom was actually right a vast majority of the time! I was just an ignorant kid who overestimated his level of knowledge.

Example: I read on reddit forums of this guy, DFV, who knows a lot about stocks. He invested a lot of money on Gamestop, and he made millions of dollars. His hypothesis on the stock being oversold, thus creating a short squeeze seems logical. Everyone seems to be making money and so could I!

Why you need to be careful: DFV was hailed as a genius when Gamestop closed at $347. But how is he doing now? If you followed his steps and decided to buy at $300, you would have been toast. The stock quickly dropped to the low $40s before slowly creeping back up to $118. 

You don’t know everything about Gamestop after reading one Subreddit. Have you read Gamestop’s 10-K filing? Do you know what its 1 yr target estimate is? If those don’t scare you away from Gamestop, I don’t know what will!

Priming

Priming is a cognitive process that occurs when exposure to environmental factors or stimulus could alter a person’s reaction later.

Example: If you have a dog, specifically a shiba inu, you might be more inclined to purchase Dogecoin. However, the fact that you have a dog should have no effect on your investments. 

Why you need to be careful: You see ads of Robinhood about how easy it is to create an account and invest. All your friends are trading on Robinhood and tell you how fun it is. The special effects on the app gamify the experience. They’re all making money from meme stocks. Time to jump in right?

Wrong!

Are they really making money or are they bragging about their wins and hiding their losses? As the Gamestop saga has shown, anybody can win for a week, and lose the next month. 

If you’re the target demographic: 20s with minimal investing experience, you have been primed to download Robinhood and jump into meme stocks. I highly advise against doing that, but if you’re still insistent, make sure you understand the risks.

What Goes Up Must Come Down Fallacy

I don’t know the official name of this one, so let’s call it the What Goes Up Must Come Down Fallacy. This is a fallacy that may lead you to avoid relatively “expensive” stocks and pour into “cheap” stocks.

Example: Amazon stock price just hit a new high! It’s so expensive! Does that mean we should expect the stock price to go down? 

Macy’s stock price just hit a new low! It’s so cheap! Does that mean we should expect the stock price to go up?

The answer to both of these questions is a resounding NO.

Why you need to be careful: New highs donot signal the price has NOWHERE to go but down.

Conversely, new lows do not signal the price has NOWHERE to go but up.

Amazon hits new highs basically every year if not every month, as can be seen in its 20-year price chart below. It would be unwise to call it overpriced and sell it short. It has a strong business model and is expected to continue its success.

Amazon price chart from 2000 to 2021
Source: Yahoo Finance

Macy’s on the other hand continues to hit new local lows. It hit local lows (not all-time lows) in 2009, 2016, 2016, and 2020.

Are these local lows a strong buy signal? Probably not. If you bought in 2016, you’d still be at a loss. 

Macy’s currently does not have a strong course toward profitability. It could likely continue its decline unless it creates strong ecommerce demand.

Macy's price chart 2000 to 2021
Source: Yahoo Finance

Putting It All Together

It’s important to understand and avoid the biases of investing which can lead us to make bad decisions.

The next time you make (or avoid) an investment, think about these biases of investing which may be impacting your judgement:

The Availability Heuristic which makes us assign a disproportionately large weight of our decision-making based on readily recalled information.

Confirmation Bias which is the tendency to seek and interpret new evidence as confirmation of your existing beliefs or theories.

Hindsight Bias which is the tendency for you to believe you could have predicted the past.

The Dunning-Kruger effect which is a bias where people with low ability incorrectly overestimate their abilities. 

Priming which is a cognitive process that occurs when exposure to environmental factors could alter a person’s reaction later.

The What Goes Up Must Come Down Bias which is a fallacy that may lead you to incorrectly avoid relatively “expensive” stocks and pour into “cheap” stocks.

Let me know your thoughts below!

Which of these biases of investing surprised you the most? What will you do to recognize and avoid them?

Wall Street Fat Cat

Learn all about saving money, earning money, investing, and hitting your financial goals. Your journey towards financial freedom starts MEOW!

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One thought on “6 Biases of Investing to Avoid Now

  1. I definitely suffer from the what goes up must come down bias ! Stocks and housing prices gotta come down right ????

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