We make investment decisions by relying on fundamental analysis to determine if a security is undervalued. If the stock market is efficient, the stocks’ prices should fully reflect all available information. Therefore, the market demonstrates rational pricing. As investors, we try to capitalize on any discrepancies on a particular stock or a new report not already accounted for to profit on that position.
Sometimes stocks may be mispriced because of the psychology involved in decision-making known as “behavioral finance.” This discipline can offer behavioral/emotional or cognitive biases to explain why markets or stocks are moving in a certain way. Learning about these biases can help us to shift these tendencies away and invest more wisely.
Having biases–cognitive and emotional– may cloud our judgment when making investment decisions. To read about how to overcome biases when making financial decisions see here. Since the coronavirus pandemic, we have changed many of our consumer habits to protect ourselves from exposure. We have quarantined ourselves to practice social distancing, buying products in bulk, and shopping online. We can make changes when needed.
Investing During The Pandemic
Stock market turbulence ensued soon after the required coronavirus-related lockdown. Investors quickly anticipated social distancing would pause non-essential activities. As a result, investors sold stocks related to suspended travel, vacations, airlines, gym memberships, restaurants, car rentals, and oil. The cruise line securities, such as Norwegian Cruise Line, looked dead in the water.
During the worst of the pandemic, investors flocked to stocks that are the beneficiaries of the “stay-at-home” trends:
- Zoom Communications, Slack, and Cisco (owns Web-ex) helped us communicate with loved ones, friends, colleagues, clients, and distance learning.
- We used more streaming services such as Netflix, AppleTV, and Disney+ for binge-watching.
- E-commerce providers (e.g. Amazon) attract those seeking bulk buying for groceries, toilet paper, and other essentials.
- Teladoc provided video conferencing with medical professionals.
- Pharma and biotechnology companies: Pfizer, Johnson & Johnson, Regeneron, and Moderna are developing therapeutics and virus vaccines we desperately need.
Are We Opening Up, America?
Coronavirus cases are climbing, so our country’s full opening is likely further in our future. The change to a Biden Administration may provide new guidelines for the governors to follow in their respective states based on case trajectories.
The stock market has a different mindset, looking to the future, not necessarily responding to daily news. We, as investors, are affected by attitudes that may blind us from making reasonable decisions.
Explaining How Biases Work
As sometimes irrational beings, we frequently depend on our intuition. However, sometimes we are unaware of how our gut feeling may be faulty. These biases affect how we think, act, and decide whether to buy or sell stocks. Often, we go against our better judgment. Learning how these biases work is a first step to guarding ourselves against becoming irrational when investing money in the market.
Biases are either cognitive or emotional. Each can lead us astray. They create behavioral patterns that may interfere with our investment choices. Cognitive biases mean we are potentially making decisions on established concepts that may or may not be accurate.
On the other hand, emotional or behavioral biases are not distortions in cognition but emotional factors that may lead to poor decisions. Emotional biases are ingrained in our brains and may be harder to overcome than cognitive biases. Marketers exploit these behavioral psychology traits to get us to spend more and buy impulsively. We are just as vulnerable when we invest in our portfolio.
Biases That Impact Our Investing
1. Anchoring Bias
When shopping, anchoring, a cognitive bias occurs when we place a lot of value in the first information we get. We often rely on the listed price when we make price comparisons. For example, seeing priced T-shirts that cost $700 in one store and another one that is $200 will cause the latter shirt to look cheap. The higher cost is your anchor price. Retailers often use a higher list price for coats on “sale” at $1,000 with a 75% markdown to $250. Now, that coat’s a bargain, but it may not necessarily be so.
Anchoring bias occurs in our buying and selling of assets. In real estate, say you purchased a 55-acre plot of land for $200,000 ten years ago. The plot is in a location that has been experiencing an economic downturn in recent years. Needing cash now, you receive an offer to buy your land for $170,000. There are no other offers on the market. You reject this deal because you paid a higher price. However, your broker tells you that recent comparables are way down, and the $170,000 was a fair price. It may be years before you see another offer, and in the meantime, you may have to borrow to pay monthly bills. The $200,000 anchor price distorted your view.
Have you had this experience? It is not easy to admit you made a mistake either when you bought the asset at a higher price or by selling below your cost. I recently had to sell land at a lower price than I sought because I felt the market had changed fundamentally.
Historical vs. Intrinsic Values
Investors often rely on the historical values of stocks or what they paid for the original shares. Anchors do not always reflect intrinsic value: the stock’s inherent value. Investors may be missing new information. For example, if you looked where Microsoft shares historically were trading, you may not want to pay “up” for the shares now because they are much higher. If that were the case, no investor could buy any stocks now because they are all higher, notwithstanding the hit the shares took in March 2020. Many have recovered a bit chunk of that fall.
Our first impressions form perceptions. However, update those initial feelings, possibly with research rather than anchoring, to affect our decisions.
2. Mental Accounting Bias
Mental accounting is a behavioral bias referring to different values people place on their money. Regarding investments, they are mentally accounting for their original costs separate from their profits on those shares.
Daniel Kahneman and Amos Tversky have engaged in several bias studies. When an investor who wants to raise cash is holding two stocks, one with a paper gain and the other with a paper loss, what will he or she do? According to Kahneman and Tversky, this bias will cause the investor to sell the paper gain before the paper loss. Acknowledging the loss is more painful, but there may be benefits we are overlooking. Remember that the loss coming from the weaker investment may provide some tax loss benefits.
We feel the pain of losing money more than the pleasure of making money. By selling paper losses, we are converting an unrealized loss into a realized loss. That is, it’s a real loss. I can recall the day (March 10, 2000) I loaded up on dotcom stocks, the peak, or the dotcom bubble for the NASDAQ Composite stock market index at $5,048.22. However, on March 13th I paid for several companies’ shares that by March 16th no longer existed. My husband brought the check over to our broker. She had a good laugh that morning on my poor timing as many dotcoms rapidly collapsed in value.
3. Confirmation Bias
“I never allow myself to hold an opinion on anything that I don’t know the other side’s argument better than they do.” Charlie Munger
Confirmation bias is about selective attention. People will remember information selectively, interpreting data to support their existing beliefs, even if the evidence is ambiguous. We tend to agree with people who conform to our ideas. Alternatively, we are dismissive of new information even if that provides evidence that is wrong but accurate. We often skim or do not read all of an article or report. You can see this behavior when a stock is dipping just as company results are out. Later, after management addresses analysts’ questions and provides more information, the stock may recover and be up for the day.
I sometimes see this bias when my students play the stock market game. For example, as a favored stock name drops, they look to support why it is down. I will see only one part of their argument presented. Yet, the opposite point of view also has merit. Looking at both sides allows them to consider that it may only be a short term blip and a possible buying opportunity. We are conditioned by social media, which often reinforces one side of a debate. That tendency is pervasive and used to protect our egos from thinking that may prove us wrong.
Did You Buy Zoom Communication Shares?
This bias may hurt our abilities when making investment decisions. For example, if you are genuinely open to deciding whether to buy Zoom shares now, then explore both sides of each decision. The upside of buying those shares is obvious. As a result of the pandemic, Zoom’s customer base has exploded in multiple areas. According to TechRepublic, Zoom’s most recent figures showed 300 million daily meeting participants compared to 10 million in December 2019. However, you should research the potential downside for Zoom shares.
Zoom has several risk factors to probe. How will privacy concerns impact growth, increased competition, new customers remain when the pandemic leaves us, and does the share price already reflect fair valuation? Ask relevant questions, and consider the pros and cons. Confirmation bias works when we may have a preference. It’s easier to make a quick analysis. Just make sure you have the relevant information to make your choice.
Talluria Study On Dots
Talluria et al. did a confirmation bias study. The researchers’ experiments sought consistency across different stimuli. In this case, the researchers asked the participants to view two successive movies featuring a cloud of small dots moving on a white computer screen. Participants reported on the direction of the moving dots after the first movie. Participants indicated the dots’ movement after the first movie then noted how the dots moved after the second movie. They recorded the dots headed the same way. However, they were moving in opposite directions.
The experiments showed that the participants’ biases. The Talluria et. al study proved that people will hold same confirmation bias even if they are making choices about dot pathways that are far less consequential than decisions about what house or car to buy, which job candidate should be hired or what school our kids should go to.
4. “Bandwagon” Effect Or Herd Mentality
The majority of us fall for the bandwagon effect whether we consciously know it or not. The bandwagon effect (or jumping on the bandwagon) occurs when people fear missing out. This tendency occurs when investors follow other investors’ investment choices. The herd mentality happens when people mimic other people’s actions irrespective of whether we may be imitating irrational behavior.
This psychological trait influences stock analysts on Wall Street as well. At times, analysts will change their thesis on a stock. They become more positive on the stock because their clients were buying the shares for their portfolios. These professionals never want to be the last one to change their rating either way and be viewed as the laggard or “me too” analyst. I found myself in that awkward position often enough.
Recalling An Analyst Experience
On the other hand, there is some difficulty standing apart from your peers. As an analyst myself, I recall feeling pressured to either stand alone on a stock or follow the herd. This particular time, I changed my rating from “BUY” to “SELL” on a favorite stock for reasons of a negative fundamental change in the company.
Within 24 hours, that company’s management “demanded” I fly down to their offices to defend my rating. I was the only analyst to go to a sell rating. Going to a sell rating was an unusual step as most companies would give the analyst the cold shoulder. It turned out that they were respectful of my opinion and listened to my advice. Only later did it look like the rating change was prescient. Within 6-9 months, the company had righted itself and was healthy again. And yes, I upgraded my rating to a buy.
When IPOs Are “Hot” And Sometimes Not
The bandwagon effect is noticeable when stocks first enter the public market. If you are fortunate to buy shares of a great company “going public” through its initial public offering (IPO) you can make good money. On the first day of trading, these stocks can average 20% higher or more. Beyond Meat, which makes vegetarian burgers and sausages, began trading at $25 a share, ending the day at $65.75. This price appreciation was among the most significant first-day pops of IPOs at that time. This stock continued its rise months afterward.
However, many stocks ultimately flop after the first-day IPO rise, such as Blue Apron. Investors clamored for Facebook’s IPO, which immediately rose after it began trading. However, it fell back to its IPO price of $38 at the day’s close. It continued to drop to below $18 in a few months. Yet, investors who aren’t able to buy at the IPO price may flock into the market, jumping on the exciting bandwagon after the new stocks begin trading, only to be disappointed later on. Among the best investors of all time and a proud contrarian, Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.“
5. Framing Effect
We often make decisions influenced by the presentation of the information. Is the glass half-full or half-empty? Framing is used often in risky investment situations. Therefore, it may all come down to the presentation of facts and how it is received. For example, when company management release earnings results to the public, they can provide either option:
Option 1: “In Q2, our earnings per share (EPS) were $1.72, versus expectations of $1.75.”
Option 2: In Q2, our earnings per share (EPS) were $1.72, versus Q1 results of $1.69.”
The results in option 2 look more favorable because of its comparison to lower numbers in the previous quarter. Company management often frames its earnings by posting two different EPS numbers. The release may show the reported number and a second higher EPS result, excluding “one-time” charges or a higher tax rate. The problem for investors is to determine if it is a one-time event or will those charges repeat themselves in the future.
Amos Twersky and Daniel Kahneman did a lot of research in framing risk. They asked participants in their study to decide between two treatments for 600 people who contracted a fatal disease. People generally avoid risk when presented with a positive frame. Treatment A would result in 400 deaths, and Treatment B had a 33% chance that no one would die but a 66% chance that everyone would die. In their 1981 study, treatment A was chosen by 72% of people when framed positively as saving 200 lives. However, when presented with the same choice framed negatively as losing 400 lives, 22% of people selected it.
6. Ostrich Effect
Ever want to avoid bad news? You start to distract yourself with nonsense work, putting your head in the sand like an ostrich. I have done this more times than I would like to admit. It sometimes occurs when you are holding a stock and you ignore bad news a company has released like missing their earnings target. Rather than sell the stock, you may delay making a decision. This bias is a form of selective attention. Yet, we may be missing information that proves that this is a buying opportunity.
The recent stock turbulence produced a spectacular drop in March. I knew that I had paper losses in my investment portfolio, so I avoided looking at my accounts. Having been around the block as an investor, I felt embarrassed, angry, and emotional at my cowardice. Realizing there were worse things than paper losses, I felt guilty knowing COVID-19 was taking lives.
Around this time, I came across the excellent New York Times journalist James B. Stewart’s article, “I Became A Disciplined Investor Over 40 Years. The Virus Broke Me In 40 Days.” He wrote of feeling paralyzed even after experiencing many market crashes. Many investors were feeling the same drop in their stomachs while looking at their retirement or investment accounts.
Stock Declines Are Often Buying Opportunities
Coined by Galai & Sade in their 2006 study, the ostrich effect means “avoidance of apparently risky financial situations by pretending it doesn’t exist.” In its 2009 study, Karlsson, Lowenstein & Seppi researchers found that investors checked their investment portfolio’s value 50% to 80% less in imperfect markets. While we don’t want to know the bad news, it could be beneficial. Investment experts point out that imperfect markets could be substantial buying opportunities. Those who participate in the market may pick up beaten-down stocks if fundamentals are alright. Surprisingly, as quickly as stocks dropped in those weeks, they have recovered a large chunk of their prices.
There is an old Wall Street saying that the market takes the escalator up and the elevator down. The saying means that the market drops faster than it rises. The uncertainty usually hangs over stocks like a cloud. However, recent trading has exhibited a rare anomaly where the S&P 500 recovered March 2020’s losses in days.I believe we may have many buying opportunities ahead unless the economy bounces back quickly, a challenging feat to accomplish.
7. Overconfidence Bias Aka Dunning-Kruger Effect
Ever sit next to someone at a holiday gathering when that someone is spouting about a stock investment they just made? They are holding everyone’s attention and speaking confidently. You may admire that person for their intelligence at first. Later, you may realize that it is not so. This bias is when people believe they are smarter and more capable, but they do not have the self-awareness to recognize it. They hold overly favorable views of themselves.
Experienced investors know the dangers of overconfidence. A few easy wins can make you feel brilliant. However, losses can be chalked up just as fast, especially during a pandemic. The cure for overconfidence is recognizing the mistakes you made by overlooking what should have been obvious. Only in hindsight are there clear signs you should have passed on that investment. The tendency to overestimate what we know is prevalent.
Be Humble When Investing
Humility, not overconfidence is what is needed when investing. Brokers and financial advisers often post statements such as “Past success is not indicative of future performance.” They don’t want you to think they are overconfident because of what they have done in the past. They tamp down your expectations and their liabilities.
The overconfidence bias is sometimes known as the Dunning-Kruger Effect. In a Dunning & Kruger study testing humor, grammar, and logic, participants scored in the 12th percentile but estimated that they were in the 62nd percentile, overinflating their skills. They found that participants with overconfidence aren’t necessarily embarrassed to learn differently because they hold strong views of themselves.
Overconfidence can get in the way of digging deeper into a topic, whether investing for yourself or others. You may genuinely believe that you know a lot in a particular area. Others like your boss know better and aren’t impressed. Losses speak more significant volumes to your clients.
8. Familiarity Bias
When you go to a gathering or a party, where do you go to first? Most of us prefer looking for friends we know. Familiarity bias occurs when we instinctively favor what we know. When investing, we may prefer securities that performed well in the past overlooking other securities that may be better. When picking stocks, you always need to refresh your knowledge about the company.
Make sure that the stock’s fundamentals and strategies remain sound. If they are, that’s okay. You don’t want to select stocks solely because they are familiar to you. A good investor should always diversify her/his portfolio. Broaden your view by picking the best stock for your holdings, not just what is comfortable. That is not to say that holding an asset in your portfolio long term may be enacting familiarity bias. Being loyal to owning good stocks with strong fundamentals but are undervalued are reasons to have them. Long term holdings of good performing stocks are great strategies that doesn’t exemplify familiarity bias to your detriment.
9. Status Quo Bias
Overnight we were forced to change our habits dramatically. As a result of the virus, we stayed home, and bulk shopped, wore masks and gloves. What you own or use is “the devil you know.” We are creatures of habit. This bias refers to our preference for the current state of affairs. Making changes can be difficult. Data shows that switching jobs at the right time can be a smart move if it helps to maximize income. Yet, many of us resist even exploring the opportunity because of the switching costs like working with different bosses, co-workers, benefits, and systems we don’t yet know.
Investors with status quo bias may resist making changes, even if it is a financially smart move. We may even hold onto a “losing” stock rather than sell it because we are continually expecting a turnaround that may never come. This bias is simlar to loss-aversion bias, which says that what you own is more valuable. I felt overwhelmed by the recent stock market volatility. As the market declined, I began to sell some of my losing stocks with higher risk portfolios to raise cash. Because I had a previous (bad) experience, I resisted selling large amounts of my winning stocks. Usually those are the stocks that come back in value more quickly.
Wine Values That Appreciate
Kahneman et al. wrote in a 1991 study about a gentleman known to have gotten several good Bordeaux wine bottles at low prices. The gentleman learned that the wine much appreciated from its $10 cost per bottle. It would fetch $200 at auction. Although enjoying this wine on occasion, this man would neither sell at auction nor buy at $200. This pattern reflects the fact that people often demand much more to give up an object than they would be willing to pay for it. Our status quo bias suits us to hold onto this object we value, be it land, wine, or jewelry, rather than part with it.
Sometimes, we may stay too long in a far more risky portfolio we bought when we were younger and unencumbered. While it was appropriate, then, reconsideration of your current lifestyle now is essential. Speaking to a financial advisor at different stages of your life may help you realize that you should modify your investments. Your children may be approaching college years as you should be thinking about your retirement planning. Diversification and risk allocation should be reviewed by you annually and conformed to your life stage and appetite for risk.
Automate Where Possible
Overcome this inertia by planning. If you recognize that you have this tendency of paralysis and not making changes, automate your bill payments and automatically enroll in the retirement plan at work if this is available. Consider target rate funds when investing. These funds automatically reallocate your investments based on changes in your age and risk tolerance. When you start a new business, plan for an exit strategy if things don’t work out rather than losing money if success is not in sight.
10. Risk Aversion Bias
Risk and returns are positively correlated. That means that if you seek low risk, you will receive low returns. Wouldn’t we all want to generate high returns with low risk? If you find one such opportunity, would you mind calling me? Risk aversion bias means we favor a certain outcome over a gamble, even if it meant lower returns. Conservative investors or those close to retirement age may choose a low-risk strategy to preserve their capital. A risk aversion bias could be under-investing their capital for a young investor with a longer horizon if they decide on a low-risk strategy.
11. Present Bias And Procrastination
This bias values the present when we are planning for the future. Present bias causes many of us to spend money on the latest new shiny object rather than save for retirement. As a result, we favor the present by not delaying our gratification. However, this bias comes at the expense of postponing our saving for retirement and other investments. Rather than saving our 401 k employer-sponsored retirement account by taking small amounts out of our paychecks, we may be overspending. That leads to ramping up big bills on our credit cards.
We procrastinate rather than think ahead to our detriment. It affects our health, including our financial well-being. This tendency suggests that some of us shop impulsively, ringing up unreasonable bills and saving less than we should. Stephan Meier’s study in 2010 found present-bias minded individuals are more likely to borrow and accumulate higher balances on credit cards. That means your debt is growing at compound rates detrimentally rather than the positive compounding growth you would get in your retirement bucket.
12. Sunk Cost Fallacy
The feeling of throwing good money after bad arises in many investment situations. A sunk cost is a cost that has already been spent and permanently gone. The problem is that we tend to hold onto investments that are underperforming well past their time it should be reasonably clear that it is sunk money. That is just a trap. Selling long term losses may provide you with the end of year tax loss benefits. Although throwing good money at losing investment may seem easier sometimes, it is better to admit your thesis is not working. Investing is not a “set it and forget it” activity.
Don’t Make Bad Decisions Worse
Investing is not a “set it and forget it” activity. If you are an individual investor, you need to set price goals for each stock you buy. I have often sold a stock after a 7%-8% price drop rather than wait until shares have dropped 25% when it gets harder to sell. If you are deliberately buying small amounts to a full position, then take advantage of improved dollar-cost averaging. Therefore, this is not a sunk cost fallacy but rather a strategy that provides lower costs for your shares.
On the other hand, I do trim stocks that rise 20%-25%, putting away small profits not to be too greedy. As another Wall Street saying goes, “Bulls make money, bears make money, pigs get slaughtered.” See this for more Wall Steet jargon explained.
Recognize those small losses will become more significant if you continue to spend or invest money you no longer support. By continuing down the road, you are making a wrong decision worse. Learn how to cut losses and consider that amount in the past.
13. The Halo Effect
Ever find yourself prone to first impressions? Many of us consider those early beliefs as important. We are often heavily influenced by one trait’s halo effect is but ignore other characteristics, whether good or bad. Sometimes certain people or companies can “do no wrong” because they have a teflon surface. We prefer to make snap decisions rather than a thoughtful analysis which is needed.
Investors may choose well-known brands like Apple, Microsoft, and Johnson & Johnson because they and their businesses are well known. When Apple successfully rolled out a number of products in a short period of time, its shares had the halo effect lasting well after the launch. While many companies maintain solid reputations for decades, be on the alert for changes that result in poor decisions.
As humans, we have biases that create blind spots in our lives. During this pandemic, we may become even more irrational. Our mindsets distort how we make investment decisions. We can outsmart these tendencies. Instead, greater awareness will allow us to invest more wisely. Be proactive and understand both sides of the argument to make informed choices. Take charge of your financial future.
Thank you for reading!
Did you recognize any biases you have? How do you overcome these tendencies when investing in assets? We would love to hear from you! Please subscribe to our blog and find more articles like this.
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.