Buffett often gives the illustration that investors would achieve superior investment results over the long term if they had an imaginary punch card with space for only 20 holes and every time they made an investment during their lifetime they had to punch the card. In Buffett’s view, this would force investors to think carefully about the investment, including the risks, which would lead to more informed investment decisions.
In order to make these informed decisions, we must learn to identify, evaluate and try to neutralise the effect cognitive biases have on our brains.
If human brains are software, biases are inadvertent errors in the code which affect our functioning.
Although man is a rational being, he is prone to lacunas in decision making which is attributable to various biases. These biases manifest while making financial decisions as well.
Loss aversion/endowment effect:
Markets are running an all-time low amidst the COVID – 19 pandemic and our experience in dealing with our investments right now may be paving the way for a strong “Loss Aversion” or “Endowment Effect” in the future – this can be described as a phenomenon where people recall investment portfolio declines more vividly than gains, sometimes even when the gains are greater. Resultantly, their innate ‘aversion’ to ‘loss’ clouds their judgment and creates doubts in their mind when making financial decisions in the future.
In our opinion, all past decisions are sunk costs and a decision to retain or sell an existing investment must be measured against its opportunity cost.
Mental accounting, in behavioural economics, refers to the different values people on money, based on subjective criteria, that often has detrimental results. For example, money received in a tax refund would be valued differently from salary earned. One is more likely to squander the unexpected tax refund money, but he will be more prudent while spending a hard-earned salary. Although they seem rational, the categories we create are often wholly arbitrary and dangerously misleading. If we are not careful, mental accounting can sabotage our investment strategies.
Recency bias describes our tendency to extrapolate our recent experience in the future. And when it comes to investing, this can have serious consequences because it skews our view of reality and the future. What happened yesterday, might not necessarily happen again today, let alone tomorrow.
When making investing decisions, it may seem like we have to predict the future which is a seemingly impossible task. When we’re faced with difficult decisions, especially during times of uncertainty and volatility, our minds take shortcuts. For example, when we are trying to predict the future, our minds naturally reach for what happened most recently – that’s a classic example of recency bias.
Albert Einstein said: “Make things as simple as possible, but no more simple.”
In seeking straightforward answers to complex questions, humans often resort to oversimplification – offering seemingly rational reasoning to a cause and effect relationship. This reason may be plausible at best and fallacious at worst – and this can affect investor decisions and lead to counterproductive results.