Kill your beloved ideas

I have been reading a few behavioral finance books on the various biases which impact us as investors (and in other walks of life too). I have picked up this topic of study for a very specific reason.

I have been analyzing my investment process and am realizing that the weakest link continues to be the various biases which commonly impact us. If I look back at the last 15 years of my investing life, I can safely say that I was fluent in the basics in the first couple of years and could identify good ideas by the fifth year.

The above statement would imply that I was an expert by year 5 and poised to be a good investor. Unfortunately the reality was far from that – you can read my journey till 2008 here. Knowing what to do is different from doing it.

Let me list a few biases and how I was impacted by them. I will also try to explore what one can do to avoid them

Social proof

This is a bias where in one is influenced by other investors and the general mood of the crowd. I wrote about a mistake I committed a long time ago – purchase of SSI and IT mutual funds during the dot com boom.

Although I was new to investing (around 3-4 years), I understood the importance of valuation and of not overpaying for stocks. Inspite of being cautious for the majority of my portfolio, I still went ahead and committed 25% of it to IT related stocks. As I look back, I recall that the main reason was that a few of my friends were investing heavily in this sector (and getting rich). In addition to this, a nice and pretty broker also recommended a few hot mutual funds (such as ICICI technology fund) which were sure to make me rich in a few years.

How could I miss?

I managed to lose 80% of my capital in a short period of six months. This was unmistakable evidence that I had made a spectacularly wrong decision. Ever since then, I have followed a few simple rules to avoid getting influenced by the crowd
- Do not buy hot stocks. If the media is talking a lot about some hot sector or all my friends are getting into it, I will just avoid it. As a result I did not touch the real estate and infrastructure stocks during the 2007-2008 period and spared myself of a lot of agony
- Do not take stock tips from anyone, especially pretty girls J

Anchoring bias

This is a bias wherein one gets fixated on a variable in the decision making process and uses that to make all subsequent decision. This is a difficult bias to recognize and overcome.

I had been following Crompton greaves limited for some time and decided to buy the stock in 2011 after the company reported poor results in the first quarter. The stock dropped quite a bit after that and I started purchasing the stock as it ‘appeared’ cheaper compared to the past results.

In the case of stocks, investor returns are dependent on future performance, but the data to evaluate that comes from past performance. It is an art, more than science, to evaluate the past results and arrive at an appropriate conclusion. In the case of Crompton, I got anchored to the price and the past fundamentals and did not weigh the state of the industry and management issues more heavily.

How should one avoid this bias? Once you have purchased the stock, it is very difficult to avoid the anchor of the purchase price and past performance. The best approach I know of is to be aware of this bias and constantly question your reason for holding a stock.

Commitment and consistency bias

This is a tendency to be consistent with one’s behavior in the past. It is a good way to behave in life – if you have been a decent and honest person once, you want to continue and be committed to that behavior.

However this behavior can cause a lot of trouble for an investor.  Once you have purchased a stock, there is a tendency to be committed to it and as a result one tends to underweight any negative information about the company.

Look at any stock boards – majority of the investors are talking about the positives of the company. If you are already invested in the company, does it make sense to find any additional information which just confirms your belief? How will that benefit your decision?

I have suffered from the same bias and I can’t think an easy way to avoid it. I have purchased value traps like Cheviot Company and held onto them even though the company continues to deliver mediocre performance and the stock price was stagnant.

The approach I take now is to rank all the companies in my portfolio in a descending order of attractiveness. This forces me evaluate more idea more objectively. Once I have my rank, I compare any new idea with the last idea in the list. If the new idea is better than the last one on the list, it gets replaced.

The title of this post comes from the concept of Darwinian selection – kill the weakest ideas to make way for the stronger one. This also reduces the impact of the commitment and consistent bias.

I plan to cover additional biases such as the authority bias, availability bias and more in the subsequent posts.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.