Herding describes the tendency of investors to unthinkingly “follow along” with dominant market themes without regard to potential risk of capital loss.AdrianHillman/Getty Images/iStockphoto
Almost every investor has attempted to copy the Warren Buffett stock selection strategy at one time or another. Most fail, not because they've misunderstood the simple technique but because the psychological discipline necessary to implement the strategy is extraordinarily difficult.
Understanding behavioural economics is at least as important to investors as stock-picking methodology so, with the help of invaluable investing blog Psy-Fi, I'll list the five deadly psychological sins of investing in an effort to help investors sidestep the limitations of the human brain.
Sin No. 1: Herding
Herding describes the tendency of investors to unthinkingly "follow along" with dominant market themes without regard to potential risk of capital loss. Herding takes many forms, notably the feeling of being "left out" of a market rally.
In the same way that the primary function of herding animals in Africa is as a source of food for predators, herding investors are excellent sources of profits for professional investors and commission-hungry brokerages.
Not every investment theme should be avoided, but investors should remain conscious of valuation and economic risk no matter how popular, or profitable, the theme becomes.
Sin No. 2: Anchoring
Anchoring is the term used to describe investment decisions based on the original price paid. In truth, the market doesn't care what an investor paid for a stock and the only thing that matters is whether conditions will get better or worse in the future.
If the outlook deteriorates, an investor should sell no matter whether this realizes a gain or a loss.
Sin No. 3: Confirmation bias
Investors should always be suspicious when they find exactly what they were looking for while researching an investment. Odds are, the research process involved discarding facts that didn't fit the pre-existing thesis and overemphasizing the data that support the original plan.
The best way to avoid confirmation bias is to actively write down everything that could go wrong with a potential investment.
Sin No. 4: Ego depletion
This is an interesting one that has nothing to do with self-image. Studies have shown that the brain has limited decision-making resources and the quality of decisions declines with each one made. (A New York Times profile described the phenomenon as "decision fatigue.")
For investors, ego depletion implies that the fewer times investment decisions are made the better, and that a less active investment style tends to be preferable.
Sin No. 5: Illusion of control
While most people are aware that correctly guessing heads or tails for a coin toss doesn't make them a genius, investors have trouble distinguishing luck versus skill where their portfolios are concerned.
The short-term path of the market is almost entirely random, usually based on sentiment. Investors shouldn't get too confident or too demoralized by investment performance over a period any shorter than six months. (Obviously, the rules are different for short-term, aggressive traders in this regard).
Researchers such as Duke University's Dan Ariely and Nobel laureate Daniel Kahneman, author of global bestseller Thinking Fast and Slow, have amassed a huge resource of studies showing the extent of poor human decision-making and most of it can be easily applied to investing.
Dr. Kahneman's paper "Prospect Theory: An Analysis of Decision under Risk," for example, remains essential reading for all serious investors.
The end result is highlighted by a study published by Richard Bernstein Advisors.
It shows that the average investor, far from beating the equity index's performance, generates long-term returns equal to money market funds.
Understanding the ways in which we can be deceived, and deceive ourselves, is an important step to long term investing success.
Scott Barlow