These mental traps may be killing your portfolio, writes The Motley Fool. Made a New Year’s resolution? You won’t keep it. Or at least there’s a 78% chance you won’t, according to a study reported in The Guardian a few years back. But you knew the odds were against you, as years of failure have taught most of us already. Yet we continue to make resolutions… and continue to fail by allowing our brains to work against us. Fortunately, for you, people fail just as often — if not more so — with their investing. This gives…
These mental traps may be killing your portfolio, writes The Motley Fool.
Made a New Year’s resolution? You won’t keep it.
Or at least there’s a 78% chance you won’t, according to a study reported in The Guardian a few years back.
But you knew the odds were against you, as years of failure have taught most of us already. Yet we continue to make resolutions… and continue to fail by allowing our brains to work against us. Fortunately, for you, people fail just as often — if not more so — with their investing.
This gives you a great opportunity to help improve your profits in the market: by noticing and controlling the psychological failings in your own investing. Indeed, these mental traps may be killing your portfolio!
1. Framing errors
“Which do you enjoy more: peas or carrots?” assumes that you enjoy either peas or carrots. You probably do, but together, our mental questions and perspectives often limit our thinking.
Erroneously comparing shares of different risks — such as comparing the upside of a penny share to a stalwart such as Woolworths Limited (ASX: WOW) — and evaluating shares on short-term criteria (if you’re a long-term investor) are classic mistakes. Fight it by taking the broadest, most rational view of your agenda, and question all your assumptions.
2. Confirmation bias
Isn’t it splendid to see a positive article on a share we already own? It makes us feel quite smart. We all revel in support for our own ideas, and prefer to conveniently forget about conflicting evidence.
Indeed, before the GFC, many of us remained tethered to the blue-sky prospects of speculative resources stocks, despite the changing facts. Companies like Platinum Australia (ASX: PLA), White Energy Company (ASX: WEC), Linc Energy (ASX: LNC) and OM Holdings Limited (ASX: OMH) have plunged more than 50 per cent over the past 3 years. The remedy is to forcibly seek out contrary views.
3. Consistency bias
You’ve convinced your wife that a share is a good buy. You’ve told your neighbours, and your workmates know as well. If you’re like me, you’ve written about it on the internet, too. And then you find a bit of incriminating evidence that you missed. What do you do?
Rationally, we all know what’s best — but if we’re honest, we have to acknowledge the strong pull to appear consistent. In life, how many times do thought leaders in a field actually admit to a mistaken idea? As with oppressive dictatorships, it’s usually only by the previous generation dying off that change really happens.
Consistency bias is incredibly powerful and, incidentally, I’m sticking to what I’ve said on the topic, no matter what.
4. Recency bias
Your football team has lost two consecutive matches. Heads need to roll. Because recent events generate stronger, more ‘real’ feelings to us, we weight them more in our mind, even if they don’t deserve it.
Momentum investors thrive on recency bias, but fundamental sorts — and if you’re reading this, odds are, you’re probably a fundamental investor — would do well to turn the volume down on the latest news. The media doesn’t make it easy, though.
5. Herd instinct
We’re drawn to the ‘safety’ in numbers, even if that safety doesn’t exist. Ditto for investment banking analysts, who often find it safest to predict roughly the same thing everyone else is predicting, with a few tweaks made for the sake of appearance. We at The Motley Fool aim to help you here, as we tend to be a bit quirky for investment banking work in the first place.
6. Survivorship bias
For every long-term corporate winner — be it a utility such as Origin Energy Limited (ASX: ORG) or something more industrial such as BHP Billiton (ASX: BHP) — often hundreds of losers have fought and lost the battle for dominance.
We don’t hear much about the losers, but focusing on the winners gives us a false picture of the competitive fire through which they, and their many fallen peers, almost certainly passed en route.
These are just a sample of the psychological traps we can fall into, and I’d invite you to Google ‘cognitive biases’ for many more. You’ll notice a common theme: they’re mental shortcuts — heuristics, as we say — that actually serve the caveman rather well. Less so the investing man.
And probably the forgetful New Year’s man as well.
Trying to sidestep these mental biases is less sexy than chasing the next big penny share. It’s a methodical, slow and boring process, which rarely shows an immediate benefit. Yet in my view, slow and steady is what successful fundamental investing tends to look like.
No matter what the season, our top stock for 2012 gives you a great combination of current income and future growth potential. Read The Motley Fool’s latest special report and find out the name of The Motley Fool’s Top Share For 2012. The report is free, but the opportunity won’t last forever. Click here now.
Originally published on Fool.co.uk.