Understanding Trading Biases

Yesterday, we discussed the great Charlie Munger's "mental models." These were frameworks that Munger constructed around his own psychology to create a process for success.

Munger understood one of the most important factors governing our investing decisions

 is the impact of human psychology. As longtime readers know, whether it's "negativity bias" or the tendency to misperceive reality, the way we make investing decisions is influenced just as much by psychology as our understanding of the fundamentals of a particular company and its stock.

It has been a tumultuous first half of the year so far, and we've seen plenty of wild moves in the markets. Let's revisit a few of the biases that impact our investing (and our lives) and see how we can become better traders by understanding them.

Dunning-Kruger Effect

Many of us have likely referenced this bias. Still, we might not be aware of the pioneering work that Cornell University psychologists David Dunning and Justin Kruger wrote about in a 1999 study. It's common to assess your cognitive ability as either greater or worse than it actually is.

In investing, we can see an example of this with an otherwise successful and discerning professional who would be willing to take a chance on a "hot" stock idea that he thinks he can understand but actually doesn't.

For example, if you went to a successful dentist with multiple practices and asked him to invest in a new dental practice or dental technology, he would likely have many in-depth questions about the venture. His bar for investing would likely also be high, as he would have much experience to draw upon to judge the investment.

This same dentist, though, hears about a new cannabis stock from his buddy at the golf course. The next thing you know, he's writing a $10,000 check to load up on the stock in his brokerage account. And then, if the stock happens to perform well, it triggers confirmation bias—and his "false" confidence grows even more.

It's important to recognize this bias and focus on finding good advisers who know what they're doing. Also, take the time to develop your own investing methodologies and conduct your own research.

Bandwagon Effect

This one is interesting because we aren't opposed to it... but we would argue that investors should harness it.

Remember: We're buying stocks, not companies. Stocks go up because there's more enthusiastic demand from buyers versus sellers, which drives prices higher.

If you can successfully identify the bandwagon-effect areas, you can make a lot of money... But the key is to try to identify the ones with an actual basis in reality, get in early, and manage your risk accordingly using protective stop losses.

Declinism

This can potentially be the costliest bias to your investing.

We would argue that every moment of human history right now is the best moment and that the progress we're making on almost every level is amazing. We will always have problems and challenges, but in aggregate, the world is getting better every day—massively so.

Take this attitude into your investing, and you'll better identify the kinds of ideas that will not only make you 10% but also turn into 10-baggers!

As I used to tell my analysts, we never made any money by not doing something... but rather by figuring out how to believe in something really big.

Sunk Cost Fallacy (or the Escalation of Commitment)

It's another aspect with huge implications for investing. This is the basis for a stop-loss discipline to mitigate risk, but it also greatly impacts our investing psychology.

One of the least-appreciated "negative outcomes" around investments that strongly go against you is how much of your time and focus it takes as an investor. We remember having that one position that went against us and cost our portfolio less than 1%. And despite this small impact, we spend more time stressing about it.

Think back to negativity bias – how negative information physically impacts our bodies much more than positive information.

Not only can managing your losses save you money, but it can also save you stress and put you in a better mindset to make better investments. Cut that loss and move on to finding the next 10-bagger.

Authority Bias

Over my entire career, I have avidly watched the financial news network CNBC and find it incredibly useful for getting a feel for the pulse of the market.

The parts that I don't find particularly useful are the opinions of most of the so-called "experts" on the network's shows.

The reality is that the majority of money managers underperform the market—and over the past decade, the number has been more than 85%. So just because they manage a large amount of money or somehow found a way to get on CNBC, why does that indicate they automatically have anything valuable to say?

As we've said before, many subjects (valuation, for one) dominate the conversation about stock investing, but they are of little or no real relevance to making money in stocks.

Do your own work, build your model of what works, and make your own decisions. Just because someone manages a big portfolio and speaks on CNBC does not mean they're necessarily better than you at making money in stocks.