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Biases that make you a bad investor By Morgan Housel
Yet so many investors -- maybe most -- fail to beat a basic index fund. Why?
Blame your brain. We come hardwired with all kinds of biases that cause us to misinterpret information and push us into regrettable decisions. Here are some of the biggest:
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Confirmation bias, or starting with an answer and then searching for evidence to back it up.
If you start with the idea that hyperinflation is imminent, you'll probably read lots of literature by those who share the same view. If you're convinced an economic recovery is at hand, you'll probably search for other bullish opinions. Neither helps you separate emotion from reality.
Charles Darwin regularly tried to disprove his own theories, and the scientist was especially skeptical of his ideas that seemed most compelling. The same logic should apply to investment ideas.
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Recency bias, or letting recent events skew your perception of the future.
When the country's in a bull market, you think it'll last forever. When the country's in a recession, you think the economy will never recover. After a banking crisis, you think another is right around the corner. Rarely is that actually the case, but it's what feels right when memories are fresh in our minds.
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Backfiring effect. When presented with information that goes against your viewpoints, you not only reject challengers, but double down on your original view.
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Anchoring, or letting one piece of irrelevant information govern your thought process.
Best example: Investors anchor to the idea that a fair price for a stock must be more than they paid for it. It's one of the most common, and dangerous, biases that exist. "People do not get what they want or what they expect from the markets; they get what they deserve," writes Bill Bonner of The Daily Reckoning.
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Framing bias, or reacting differently to the same information, depending on how it's presented.
Example: "Google shares surge to highest level in five years."
"Google shares haven't gone anywhere in five years."
Both statements might be true.
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Skill bias, or when education and training cause confidence to increase faster than ability.
The best example is the management team of the hedge fund Long Term Capital Management, which was staffed thickly with doctorates and two Nobel laureates. The fund exploded in 1998 under an incomprehensible amount of leverage. Behind the failure was raging overconfidence. "The young geniuses from academe felt they could do no wrong," Roger Lowenstein wrotein the book "When Genius Failed."
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Hindsight bias.
Out of literally millions, only a handful of investors truly saw the financial crisis coming.
If you disagree with that statement and respond, "No, any idiot could have seen it coming from a mile away," you're suffering from hindsight bias. Only after the fact do all the puzzle pieces make sense. That's why bankruptcies outnumber billionaires.
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Pessimism bias, or underestimating the odds of something going right.
Financial adviser Carl Richards writes: "We focus so much on protecting ourselves from negative surprises (job loss, disability, divorce, death ... the whole catastrophe) that we forget to factor in the positive ones (a raise, a business that works out, a new career, a new bull market) that can sometimes change our entire outlook."
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Illusion of control, or thinking that your decisions and skill led to a desired outcome, when luck was likely a big factor.
If you've ever made money day trading and patted yourself on the back for a job well done, you're probably a victim of the illusion of control.
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Escalation of commitment, or the classic "throwing good money after bad."
This includes doubling down on a plunging stock, not because you believe in its future but because you feel the need to make back losses. It happens all the time at blackjack tables, too.
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Risk perception bias, or attempting to eliminate one risk but exposing yourself to another, potentially more harmful, risk.
Here's an example I've written about before: In the year after 9/11, air travel fell and car travel jumped. Understandably, people suddenly felt planes were more dangerous than cars.
But statistically, the opposite is true. In his book"The Science of Fear," Daniel Gardner notes that if there were a 9/11 every day for an entire year, the odds that you'd be killed by terrorists would be one in 7,750. By comparison, the annual odds of dying in a traffic accident are one in 6,498.
German psychologist Gerd Gigerenzer estimates that the increase in automobile travel in the year after 9/11 resulted in 1,595 more traffic fatalities than would have otherwise occurred. Add the impact that stress had on people's health, and the reaction to 9/11 may have been more deadly than the attack itself. "People jump from the frying pan into the fire" said Gigerenzer.
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Morgan Housel, a columnist at The Motley Fool, is a two-time winner, Best in Business award, Society of American Business Editors and Writers and Best in Business 2012, Columbia Journalism Review.
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