Investor Biases

It’s funny what a bull market can do to our brains.
James Osborne, president of Bason Asset Management in Lakewood, Colo., recently met with a new client who benefited handsomely from the nearly six-year upward run by stocks.
The client balked at cutting his stake in one stock after it had grown to more than half his portfolio, even after Mr. Osborne explained the risk of not diversifying. 
Asked if he would put half his money into the same stock if he was building a portfolio from scratch, the client said of course not.
“He saw these gains as ‘house money,’” Mr. Osborne says. 
Money earned passively in the market, rather than from toiling at work, can feel easier to gamble with. It is a dangerous bias psychologists call the “house-money effect.” 
The client ultimately diversified, “but the behavioral bias of the house-money effect was very powerful,” Mr. Osborne says. “This is what happens after bull markets.”

Everyone wants to assume they can think rationally. But with bear markets now a fading memory—and with volatility roaring back this past week—now is an important time to understand the common behavioral biases that cause investors to make regrettable decisions during bull markets.

Here are five others.

The backfire effect. This is a powerful bias that causes us to double down on our beliefs when exposed to opposing viewpoints.
“We think this response occurs because people respond defensively to being told that their side is wrong about a controversial factual issue,” says Brendan Nyhan, an assistant professor of government at Dartmouth College, who has studied the backfire effect in politics.
“In the process of defending that view, they can end up convincing themselves to believe it even more than they otherwise would have if they had not been challenged,” he says.
The same flaw can run wild in investing debates.
If you are convinced that we are in a lasting bull market, how do you feel when you hear someone say that stock valuations are historically high, or that we are overdue for a correction?
If you find yourself so critical of opposing views that you become even more convinced the bull market will last, watch out. Once your priorities shift from determining the truth to blindly defending your original views, you have lost the ability to think rationally.

Confirmation bias. This flaw causes us to seek out only information that confirms what we already believe.
Access to financial opinions has exploded in recent years, thanks to the rise of Twitter and blogs. That is generally a great thing. More smart investors are speaking their minds than ever before.
But it can be dangerous, because no matter what you believe—and no matter how wrong those beliefs may be—you can likely find dozens of investors who agree with you. Having other people confirm your views may cause you to become more convinced that those views are correct.
Charles Darwin had a knack for obsessing over information that disproved his own theories. Investors should try to do the same.

Anchoring bias. This phenomenon causes us to cling to an irrelevant piece of information when estimating how much something is worth.
Your opinion on how much a stock is worth may be anchored to how much you paid for it. If you paid $100 for a share of Apple stock, you are probably more likely to think shares are worth more than $100 than another investor who paid $80 for the stock.
But the market doesn’t know how much either you of you paid for the shares. And it doesn’t care what either of you think is a fair price. Markets will do as they please, regardless of what price you are fixated on.

Recency bias. This one is simple: It is another term for the tendency to use the recent past as a guide to the future.
People like patterns. If stocks have just gone up, the natural tendency is to assume they will keeping going up—at least until they go down, and then we assume they will keep going down.
The S&P 500 fell 37% in 2008, and investors pulled more than $300 billion out of stock mutual funds from January 2009 to December 2012, according to the Investment Company Institute, a mutual-fund trade group.
Stocks have since had a blistering few years, and investors put $205 billion back into stock mutual funds from Jan. 1, 2013, to Dec. 3, 2014.
Markets move in cycles, but people forecast in straight lines. That is recency bias, and it is particularly dangerous after a long bull market.
Blind-spot bias. This—the most dangerous investing bias—is a flaw that causes us to think the biases described above affect other people, but not ourselves.
In his book “Thinking, Fast and Slow,” psychologist Daniel Kahneman wrote that “it is easier to recognize other people’s mistakes than your own.” 
That’s something to think about as you analyze your own investing behavior.