Monday, September 28, 2015

Behavioral Biases: How They Influence Investment Decisions

When a stock performs well -- and as just one example Amazon's (AMZN) stock, to say the least, certainly has over the long haul -- it's easy to become convinced, at times incorrectly, what ended up happening was obvious all along.

That's hindsight bias -- the belief, after the fact, that something was more predictable than it actually was -- and is just one among the many biases that impact investor behavior and results (and generally not in a good way).

Now, here's just some examples of those who, more or less, previously expressed a favorable view of Amazon as an investment.*

Amazon 'Undervalued': Portfolio Manager

Analysts Bullish on Amazon

Ken Fisher Still Bullish on Amazon

And some from those with a less favorable point of view...

Not Even Jeff Bezos Would Buy Amazon's Cash Flow

Three Reasons Why Amazon's Cash Flow Is No Comfort

Don't Be Fooled by Amazon's Cash Flow

There are, of course, many more examples of thoughtful but opposing views to be found. The same stock but very different views. For those with an open mind this can and should be a good thing. Unfortunately, it's easy to make the mistake of only seeking information that's consistent with one's own thinking.

Of course, investment decisions should never be based upon what someone else thinks. Ultimately, each investor needs to come to his/her own conclusions. Yet it's important to avoid making the mistake of only giving consideration to information that reinforces a particular view -- however flawed or biased it might be -- while mostly ignoring contrary facts and logic.

Keep in mind I'm simply using Amazon as an example. The same thing, in general, can be applied to other stocks though naturally the specific circumstances will always be unique.

Personally, I respect and admire Amazon and Jeff Bezos** but have never considered owning the stock for a simple reason:

I just don't know how to value it within a narrow enough range.

That doesn't necessarily mean I'll be surprised if the company proves to be very valuable over the long run.

In fact I won't be at all.

It simply means I don't understand it well enough especially when compared to alternatives; it means my estimate (within a range) of likely future returns can't be compared in a meaningful way to those things I think I do understand better; it means that if I can't value something with enough warranted confidence, it's by definition impossible to determine what price represents a sufficient margin of safety.

So, as a result, it has never made any sense for me to consider owning Amazon's stock. Behaving otherwise would likely be, at least in my case, a recipe for subpar results or worse in the long run.

Now, lets assume for some reason I had long ago decided to buy Amazon (again, I've always had -- and continue to have -- zero interest in doing so) and it happened to work out well for me. This result would have been mostly, if not entirely, due to pure luck. In other words, not being able recognize when good fortune more so than being right was the reason for the good result will likely lead to future costly mistakes and reduced results.
(Even though, due to luck, the results were favorably impacted by the Amazon investment my view is that the lack of discipline, ultimately, is likely to hurt results.)

It's about knowing and staying within limits.

Those who buy any stock without carefully considering the reasons why things may not go as well as hoped are potentially setting themselves up for permanent capital loss.

Beware of confirmation bias.

Beware of investor overconfidence.

These can prove expensive in the long run.

If not carefully managed these and other biases can lead to big and unnecessary mistakes.

The important thing to remember is that biases are -- in the context of investing -- not just someone else's problem.

For most of us -- if not all of us -- bias blind spot is a real factor.

It's easy to point to what worked well with the benefit of hindsight. For every Amazon -- at least in the real world -- there will be many that seem to have great potential but don't work out nearly so well.

That simply won't be obvious before the fact.

It will only become obvious when looking through the rear-view mirror.

Knowing what to avoid starts with buying only what you understand.

That means, inevitably, sometimes it's necessary to "miss" what after the fact proves to be an excellent opportunity.

Some investors no doubt were able to see Amazon's potential long ago and were rewarded for it.

Still, it's important to try and be objective about the reason something worked out well.

Easier said than done.

Sometimes, an investment might work out well due to brilliant insight and foresight.

Other times, good fortune might have played a significant role.

Knowing the difference can eliminate errors down the road.

Maybe some think Amazon's prospects and intrinsic business value have always been, and remain, plain to see; or maybe that's, at least in part, simply hindsight bias at work.

Adam

No position in AMZN

* Naturally, views such as these are not necessarily static, may have changed, or at some point may change.
** Some concerns and criticisms have also been previously highlighted.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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