We all develop prejudices about how things work or are going to work out based on our life experiences. While these biases can sometimes be beneficial, having a biased approach can lead to poor decision making when it comes to investing. Yet we are all affected by investment biases to some degree and this prevents us from reaching our investment goals.
Charlie Munger, a friend and business partner of famed investor Warren Buffett, identified and discussed 24 of these cognitive biases at Harvard University in a 1995 study titled “Psychology of Human Misjudgment.”
In this blog, we will discuss 7 major personality biases that can lead us to make poor investment decisions, as discussed by Charlie Munger. Additionally, we will also discuss the various steps you can take to reduce, if not eliminate, the effects of these biases.
Bias #1: Consistency and Commitment Bias
According to Charlie Munger, it is not unusual for the human brain to favor one specific opinion or idea over all others. There are two major stages through which this type of bias occurs. The first step is the introduction of the idea and the second part the person assumes that he came up with this opinion in the first place, so it must be correct.
This does not happen immediately and involves relatively small actions in order to develop a consistency of behavior that becomes a habit over time. Now, as the individual develops continuity of action through repetition, this leads to commitment to the decision, regardless of whether the decision or conclusion is true or false.
A common example of this type of behavior is when well-known investors publicly speak in favor of or against stocks they own or do not own. For example, consider the case of Bill Ackman, a well-known investment expert who went live on CNN to say that he would use his considerable personal wealth to short shares of Herbalife, a company whose business he personally owns. dislikes from But, even though he personally shorted the company’s shares from 2012 to 2020, that turned out to be wrong and the company’s stock didn’t take a nosedive. Bill Ackman and his supporters lost billions as a result of his personal bias.
Perhaps the best way to manage consistency and commitment bias was put forward by Guy Spear. According to him, it is bad practice to go public with individual stock ideas and not because of the possibility that other investors will steal the best ideas. According to Spears, one should not discuss stock tips publicly simply because it is hard to publicly admit one’s mistake at a later date.
Bias #2: Incentive Bias
Selfishness and rewards are the two most common drivers of human behavior. Therefore understanding the role of incentives is the key to identifying incentive bias in individuals. That’s why Charlie Munger says that the right kind of incentive can play a vital role in shaping investor behavior correctly.
An example of how this can be implemented is by FedEx providing the U.S. did in. Once it moved from its earlier hourly structure to a per-shift compensation structure, the company was able to operate more efficiently by shaping the right behavior in its employees.
However, when the incentive structure and commission payment design is poor, it can create a number of problems due to incentive bias. Incentive bias due to higher commissions is a major reason why many financial advisors recommend buying an endowment plan instead of a term life insurance plan or a unit linked insurance plan (ULIP) instead of a mutual fund. This often happens even if the latter product is better suited to the needs of the individual/investor. But since commissions are higher than endowment plans and ULIPs, the financial advisor can offer these products to potential investors.
To reduce the potential impact of incentive bias, investors should learn about the various investment options themselves and seek a second opinion whenever possible. This will reduce the chances of misselling of financial products.
Bias #3: Opposite Bias
Contrast bias arises from the fact that the human mind compares an existing situation with a similar situation in the past to draw parallels. This bias is commonly exploited by real estate agents, who may initially show you some lousy options before showing you what they really want to sell. That way, the contrast bias will make the final asset look like a better deal than the ones shown before.
That reverse bias is one of the key reasons why investors get bullish about stocks at their 52-week lows. In investors’ minds, a stock available at these low prices may seem like an attractive buy in contrast to the same stock that was previously priced significantly higher.
The best way to manage contrast bias is to think of a stock’s absolute value rather than make a relative comparison. For example, consider the movement of Tesla stock on the US NASDAQ exchange. It was trading at US$932.57 on December 17, 2021, indicating a 18% drop in Tesla’s share price during the previous month. But if investors take a closer look, they can also see that Tesla stock has given returns of more than 1000% over the past 2 years. Therefore, as a retail investor, you need to keep such information in mind to minimize the risk of reverse bias while investing.
Bias #4: Social Proof Bias
The root of the social proof bias is the belief that a decision taken by the majority is correct. While in some cases, this can act as a shortcut for determining the right course of action, the herd is almost never right when it comes to choosing investments. Nevertheless, social evidence bias can play an important role in driving investment decisions.
Now, social proof also has a good side as it helps to define what is acceptable or normal behavior for the average person. This may include being polite to others, dressing appropriately for a social event, etc. However, on the other hand, following the herd can lead to wrong conclusions as well. Not following the herd is, in fact, one of the key lessons of value investing.
This is aptly reflected by the movement of the stock markets. If the majority of investors are greedy, the market continues to move upward, whereas if the majority are fearful, the market corrects significantly.
To reduce the impact of social proof bias on your investment decisions, you can opt for one of two methods. The first method is to create a checklist to help you determine whether the majority view or the opposite (minority) view is correct with respect to investment choices. If designed properly, such a checklist can help you find the right investment option. Alternatively, you can develop the habit of seeking only specific information about why a particular investment is being preferred or written off by the majority. Getting to the root cause of market behavior can help you figure out the appropriate course of action for you.
Prejudice #5 Liking Prejudice
It is natural human behavior to prefer certain people or products over others. This can lead to a bias where we often find it easier to overlook the shortcomings of people or products because we like them. What’s more, liking bias can also lead to unfounded assumptions. For example, the preference bias can lead us to believe that a good-looking employee will be good at their job, even if we have no way of proving it. In the case of investing, liking bias is simply “falling in love with a stock or investment” and this can happen for a number of reasons.
During the Internet boom of the 1990s, adding “.com”, “.net” or the Internet as a way for companies to successfully exploit preference bias. In fact, the share prices of some companies rose as much as 74% within 10 days of adding the .com or .net suffix to the company name. In recent years, terms such as biosciences, agritech, lifesciences, greentech have been applied to company names with the same purpose of exploiting preference bias for inclusion.
Therefore, rather than valuing stocks based on sentiment or personal likes/dislikes, one should use analytical skills and tools to eliminate the potential impact of preference bias.
Prejudice #6: Excessive Self-Esteem Bias
This bias emerges from 2 key aspects of human behavior – underestimating one’s own abilities as well as underestimating everyone’s potential. We all have some degree of self-esteem bias and this gives us the confidence to try new things and experiences. However, having a high self-esteem bias can make a person overconfident and this can affect all aspects of life, including choosing investments.
One way to do this may be to underestimate its ability to choose the top-performing investments compared to its peers. But, if these investments do not produce the desired returns, investors with excessive self-esteem bias may not be able to determine the root cause of this poor performance. In such a situation, the chances of repeating the mistake increase manifold.
One way to curb the potential impact of excessive self-esteem bias is to use a checklist, as discussed by Dr. Atul Gawande in his book “The Checklist Manifesto.” This can help eliminate bias with relative ease.
Bias #7: Authority Bias
It is not uncommon for many people to blindly follow instructions from executives such as parents, policemen, doctors and even “investment experts” who discuss stock tips on TV. It may seem like an easier option to follow the instructions of those in power than to make every decision from the very beginning, but it can be quite harmful when choosing an investment. Instances of authority figures being misunderstood, their instructions being misunderstood and even tampering behavior on the part of officials have been reported.
There is no dearth of self-proclaimed stock market experts on TV and various social media platforms these days. This can make it difficult for the average investor to break out of the noise. But blindly following the recommendations of such stocks can do more harm than good in the long run. That is unless you supplement this advice with a second opinion or ensure that the source of the advice is a competent person.
ground level
In some cases, a single investment bias can lead to a specific course of action that adversely affects our long-term investment goals. But in many cases, our investment decisions are liable to be influenced by multiple biases at the same time. In addition, we can adjust the facts of a particular situation to suit our view of the world or provide an argument for making a specific choice. Avoiding and mitigating the effects of personal biases goes beyond actually making us good investors, it can also provide the building blocks that make us good people. After all, John Bogle, the father of index investing, said – “Investing is not as difficult as it looks. Successful investing involves doing a few things right and avoiding serious mistakes.”
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