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The Tricks Your Mind Plays On You: 20 Biases That Impact Your Investment Success (Part 2/3)
In the second part of this series, we continue going through 20 selected types of biases that can affect our decision making in life and investments. The first five were discussed in Part 1. Please read Part 1 if you have not done so already!
The green lumber fallacy refers to a kind of fallacy where one mistakes one important kind of knowledge for another.
The name derives from an example narrated by Nassim Nicholas Taleb:
"Joe Siegel, one of the most successful traders in a commodity called “green lumber”, actually thought that it was lumber painted green (rather than freshly cut lumber, called green because it had not been dried). And he made it his profession to trade the stuff!"- Antifragile
Taleb outlined a second similar situation: a star Swiss Franc trader whose inability to locate Switzerland on the map didn’t hinder his ability to make money trading its currency.
The green lumber fallacy happens when you mistakenly think that certain knowledge or skill is helpful for an investment decision when in reality it has no impact. What works in the real world does not necessarily match our stories of why it works. Unimportant details can often seduce us into thinking we know the reasons for something when we really don’t. Only time filters reality from narrative.
Our narratives about the type of knowledge or experience we must have or the type of people we must be in order to become successful are often quite wrong; in fact, they border on naive. We think people who talk well can do well, and vice versa. This is simply not always so.
Why to avoid:
It seems confusing at first, and quite counterintuitive. Why should more knowledge hinder your success?
The problem of green lumber fallacy lies in the reliability and depth of knowledge - typically the deeper you go, the more unreliable the knowledge becomes, and if you know the surface behavior perfectly well, the increased complexity of the deeper knowledge may lead you astray, even if it is correct.
How to avoid:
It is better to focus on what you know, and what you need to know instead on focusing on the intricacies that may not bring additional benefit.
We hate losing money. We hate it so much that studies have found that we feel our pain from losses twice as keenly as our joy from wins.
Loss aversion is people’s tendency to focus on avoiding losses more than making gains. It can make people avoid investing entirely, or invest too conservatively.
If someone is given an option of earning $1000, but there is a probability that he might lose $500, he will never go for it. For them, the pain of losing $500 is always bigger than the joy of gaining $1000.
Why you should avoid it:
Nobody like to lose especially when it comes to our investments. Warren Buffett said “never lose money” and that is a good rule. But if you are too loss averse, you may actually end up losing more than if you weren’t.
For instance, you may have a stock that made you a return of -10%. A person with loss aversion may be so afraid to take the loss that they hold on to the stock for no other reason than to not take a loss. Then the stock perhaps falls to -20%. By being too afraid to sell the stock you actually lost more. I am not saying that you should always sell a negative stock. What I am saying is the ‘sell decision’ should not be biased on an aversion toward loss.
Also, loss aversion causes us to avoid small risks even when they're probably worth it. It's why people save rather than invest, even though inflation will erode the value of their savings. They do so because they fear "the volatility of the stock market" or the cryptocurrency markets.
In summary, loss aversion can:
Stop and prevent the investor from selling or getting rid of loss-making investments. It can make you hold on to losing investment and sell the winners instead.
Make investors overthink on avoiding risk when assessing possible gains. Evading loss is prioritized over making a profit.
How to avoid or overcome loss aversion:
Losing is part of the investment game. No risk, no gain. Prepare an investment plan before you get into a trade. Give your investments some trading space to move and don’t set your stop losses too tight.
Giving up due to loss aversion bias without justification would reduce your chances of winning. For example, if you don’t start up a business you always dreamed off just because you worried about losing money, you will lose.. in the real sense.
Know in mind, the greatest risk is living a risk-free life.
Alter your attitude. Don't leave it up to emotion. Create an investing strategy and stick to it. Make a mental effort to adopt some risk.
The "disposition effect" is a term that describes investor behavior in which they have a tendency to sell winning investments too early before realizing all potential gains while holding on to losing investments for longer than they should, hoping that the investments will turn around and generate a profit.
This is related to the loss aversion discussed above.
The disposition effect is the tendency to buy more when a stock falls and sell prematurely when a stock is rising. A rising stock tends to continue to rise. While a falling stock often falls for a longer time than you expect.
Why to avoid:
For that reason, the disposition effect can make you lose money by buying or selling too early. The opposite is actually what you should do. Cut your losses and make your profits run.
People often tend to favor what they are familiar with. This can cause bad decisions as your other choices are given less value than they may deserve.
This is not always a problem. You can have an advantage by being familiar with what you are investing in. But you should not make too hasty conclusions.
Familiarity bias is like being at a party where it’s easier to chat with friends than mingle with strangers — but it can lead to suboptimal diversification as investors stick to familiar ‘go to’ assets, rather than exploring the full universe of options.
When investing, you might have a bias to your home country, a bias to the company you work for, or a bias to companies you “like”. Some investors tend to buy stocks of companies whose products they like, or whose products they use frequently. There is nothing inherently wrong with this approach – in many cases, it means buying a company that makes a profitable product and runs a profitable business. But investing should involve more analysis and ongoing research into a company.
Why to avoid:
The result of familiarity bias is that it can overly influence investment portfolio construction, and hence investment outcomes. It can result in investors not exploring the full range of choices, and excluding a wide range of valid investments for reasons other than the investment case.
If we go back to the friend analogy: it’s like being at a party where it’s easier to chat to someone you know than to make the effort to speak to a stranger. But that interaction outside your comfort zone might be where the real gains are.
This bias makes you attribute successes to yourself while failures are attributed to external factors. If you buy a stock and it goes well you pat yourself on the shoulder. But if the stock plummets you blame the market or something other than yourself.
Why to avoid:
Self‐attribution teaches investors to unwittingly take on inappropriate degrees of financial risk and to trade too aggressively, amplifying market volatility. Self‐attribution bias often leads investors to trade more than is prudent. This bias leads investors to “hear what they want to hear”.
Self‐attribution bias also prevents you from learning from your mistakes.
How to avoid:
Every time you make an investment decision and it does not go as you expected, you should try to see if you overlooked something in your analysis. If you blame external factors every time, you will keep doing the same mistakes.
The term sunk cost fallacy describes our tendency to commit to something just because we've already invested resources in it—even if it would be better to give up on it. It makes you invest more money in a losing project because of previous investments. The more you invest in something, the harder it becomes to abandon it.
We’re reluctant to recognize that money already spent is, well, gone. Say your car breaks down and you spend $4,000 on a new engine. Then, it breaks down again a month later and the mechanic says you need a new transmission for $3,000. Your emotional response might be, “I have to pay to fix the transmission, otherwise I wasted that $4,000 on the engine.”
In truth, that $4,000 is already gone. It’s a sunk cost. Also, it is very likely that the old car will keep costing you money, so you are likely better off spending that $3,000 on a new one.
As another example, have you ever finished reading a book you knew was awful 50 pages in, or watched a three-hour movie even though you knew you did not like it in the first 15 minutes? Then you may have fallen victim to the sunk-cost fallacy.
As you saw from the examples, the costs can be money, effort, time or other things that are invested into something. Sunk cost bias makes you refuse to cut your losses and acknowledge that you can't get back those "sunk costs."
Why avoid it?
The thinking behind sunk-cost fallacy is similar to the loss aversion bias discussed above. It can make you act foolishly and incur a further loss.
Any investment in your portfolio that is not ultimately going to help you should probably be offloaded. So tell yourself that whatever money you're putting into it now is blocking you from another, potentially better opportunity.
Commitment is important in business, but there's a fine line between perseverance and falling prey to the sunk cost fallacy.
How to avoid or overcome it?
It’s tough. Nobody likes losing. When we lose, the feeling is awful!
But saometimes you should cut your losses and walk away. Just because you have invested some money you should not keep putting more money into a falling stock hoping to regain your initial investment. Just walk away. And just because you invested a lot of time in researching a cryptocurrency does not mean that you should invest money in it if you are not otherwise convinced that it is a good investment.
Practice awareness and logical thinking to make rational decisions.
Determine your limit for loss and gains before selling or buying further. The concept of anticipation reduces the agony of losing.
List out the pros and cons of the next action. This gives you a clear view of whether it’s a worthwhile action.
Everyone experienced failures during their lifetime. But these fails are the best educator. Allow yourself to fail sometimes but learn from the failure and plan for a way out.
If a product, strategy, partnership, or other work endeavor isn't working, it can be hard to cut ties and move on. The general advice here is to always reevaluate your processes in light of new evidence.
Journaling is also recommended as a way to release your mind from past choices. You can use a journaling app to track your projects and determine which investments are paying off, which are likely to pay off soon, and which you should abandon before they drain you.
In the upcoming third and final part of this series, we will continue going through the rest of 20 selected types of biases.
Stay tuned, and please be alert to these biases in your life and investments!