Stock market investing – IFB29: Betrayal by Recency Bias and Other Psychological Factors

Stock market investing

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Welcome to the Investing for Beginner’s podcast I’m Dave Ahern, and we have Andrew Sather. Tonight we’re going to talk about investing with your brain we’re going to talk a little bit about how your thoughts can affect the decisions that you make when you invest.

Charlie Munger is one of my big heroes, and he has written many great articles, speeches, a few books about biases and tonight we’re going to talk about some of the more common biases and Andrews going to go ahead and start us off by talking about the recency bias.


Andrew: yeah so obviously we’re all human beings, and something I love to preach constantly is how the stock market is very emotional.

We got fear, we got greed, and it’s because it’s made up of all these people and there are some common psychological aspects that we as human beings all share that as investors that can affect the way we behave.

Many of times we’re not aware that this is things that are influencing our decisions. So, if we can kind of cut that off at the beginning before it can negatively affect it can help our performance recency bias this is the idea that something that just happened is more likely to happen.

An obvious example of this is when you see trend followers, and you know they see a 1-month chart and it just has the price going straight up.

The recency bias would say that you know as an investor you expect that stock to continue that trend or you may have the stock that’s been flat for like two years because you see that this price is moving. And the price has nothing to do with the value of the business what’s going on in the business. We’re not digging into the financials

and looking at how are the assets changing are the earnings changing strictly looking at the charts.

I remember particularly when I first started out I would often let the last two years or last five years or even six months of stock price data kind of influence how I perceived the future of the stock to be likely to happen. And it’s completely just a ridiculous thought there’s like it’s like a coin flip where you know if you start to see heads consecutively.

We have this idea where there are things like momentum and things like you know superstitions that certain streaks can continue some in some areas like sports.

You know this can happen when you have human beings, and they’re you know their confidence and things like that effect how their performance is going to go on. But when you have companies and things that you know things that are very mathematical in the sense that if the company gets great earnings, it’s going to.

It’s you know if a company sells X number of products it’s going to have this amount of earnings, and as the stock prices fluctuate through the years, the chances of a stock going up or down can be close to 50%.

You look over a very long period of the time I’ve seen the numbers, and I have looked at the sp500. And took all the daily changes in price and put them out on the big spreadsheet and looked and the percentages are very close to 50/50 slightly tilts towards the market going up.

While it does fall further when it does fall well more of the days go up and down, but so you have really like a problem a probability kind of like a game of chance kind of like a coin flip on whether a stock can well go up or down the following day.

It’s it’s not something that they’ve done Studies on this – don’t quote me particularly on the exact study but they have a study that says basically whatever a stock did the day before does not correlate whatsoever with how the stock will perform in the next day the next week.

Things of that nature so that is a big aspect of recency bias and it’s something that can kind of cloud the way that we look at stocks the market in general and if we start to make decisions particularly on price.

We know we talk about that all the time where you want to focus on value and not so much on just the price aspect of stock. You want to look for companies that are growing and not just stock prices that are growing. So I guess another way to look at recency bias mean that’s a big one when it comes to recency bias and I think it’s something that we should all be aware of and try to avoid it when we’re trying to purchase stocks.

Dave: I like what you were saying about the recency bias you know something that I was reading recently speaking of recency bias recently haha that’s you know the hot hand theory that you hear about in basketball.

You know the statistical likelihood of a player making another shot after he has the hot hand you know he comes down, and he makes two or three shots in a row and all sudden he’s got, and you start feeding them the ball.

they’ve done statistical analysis, and again you can quote me on the exact study because I don’t remember the exact details about it, but the one I do remember about the study was that there is no statistical proof the shows that they quote unquote have a hot hand.

It comes down to just the statistical anomalies of the guy happened to make a couple of shots in a row. They would bet that he would make another shot because he made the previous two and it does not correlate to the previous two shots, so that was a great way of illustrating to me what a recent bias was.

and a big reason why we’re talking about the biases tonight was that you know we as humans, you know our thoughts and makes such a huge impact on our on our actions, and we’re investing.

Warren Buffett has said many times that you know he his ability to turn off his emotions when reinvesting is what he feels like has made him a successful investor. That he you know doesn’t fall he’s aware of these biases. Charlie Munger is aware of them, a lot of the great investors are aware of these ideas, and if you’re aware of them, then it can help you control them.

Can you eliminate them? I don’t think so because we’re all humans, and we all have emotions, but if you have the idea of what some of these things are going on. It enters your head about it you can think about something like a recency bias or some of the other ones that we’re going to talk about tonight. That can help you manage those thoughts when you’re trying to decide whether you want to buy this or buy that or sell or whatever it is you want to do you. Now you can try to make a more rational decision based on the numbers and the facts as opposed to your emotions because when you buy an emotion that’s a lot of times when you’re going to make a big mistake.

Andrew: let me beat the dead horse a little bit- another example of recency bias, and I confess to falling for this. And this was very recently so something you can do kind of look at the way the market has been cycling and then because that’s what happened in the past you extrapolate into the future.

If you think about the last stock market crash we had that was 2008-2009 the bull market that ran you know the previous crash before that was 2000 2001. So we had about seven to eight years depending on where you want to start and stop at the bull market, and I know a lot of people as well as myself figured because-because we’re influenced by her bias we tended to think well what happened and just recently could probably happen now.

So I kind of thought that the end of the bull market would be about six to seven years after 2008-2009. So even though I didn’t know so, the good thing have I had a system in place I had my dollar cost averaging I had the $150 a month in the personal portfolio that I always talked about. I had that in place, so it didn’t matter what my brain was trying to trick me into thinking I was still going to dollar cost average and it wasn’t-going to affect me, but I still had this real big cautiousness, and I think you still see this in the market today.

There was an article I read that talks about how Millennials we are we are sounder invested as Millennials. That the percentage of millennial investors is a lower percentage than even pre depression days. I mean I guess like you compare age groups and those type of things, so we have a lot of millennials that aren’t even participating in the market because you burned them know either maybe they weren’t personally burned, but they saw like just a lot of carnage in the stock market.

You also have a lot of you know obviously we’ve had a bull market we’re recording this August 2017, and it’s still pretty strong. I mean the last couple days have been rough, but for the most part, we’ve pretty much smooth sailing. And yet even though we’ve been going on for six-seven years didn’t see that crash that the2008/2009 saw the same kind of period, I don’t want to say like the exact the same price to earnings valuations

We didn’t see that crash that the 2008/2009 saw the same kind of period. I don’t want to say for the same price to earnings valuations but higher than average price to earnings valuations across the entire market, but you know this bull markets different.

What that article was saying is that you know you don’t have the irrational exuberance that you saw, for example during the dot-com bubble. Where people were just jumping in, and you know just throwing money and forgetting about any rational conservative basic logical kind of reasoning when it came to putting money into the stock market.

So I guess in a sense that helps investors because we were burned so bad in2008 and 2009. A lot of investors are

more conservative when it comes to you know not getting too crazy about the market not just blindly jumping in, but at the same time if you’ve been listening to us for any time at all you do know that we see pockets of the market where there are big time bubbles, and valuations are getting really high.

all that to say be cautious of recency bias there are a lot of different ways it can affect you and don’t think that because something happened in the past especially recently don’t

let that effect how you think the future will be because you can’t you really can’t predict the future at all.

And to think that what happened just recently will happen again and that’s just setting you up for failure.

Dave: you’re right on that all right, so the next one we ‘re going to talk about is hindsight bias and this one’s pretty self-explanatory. You know they say that hindsight is20/20 that you could look back at the past and you can predict what would have happened in the past.

Well duh I mean everybody can see that, and you know with

Investing you can fall into this trap as well. You know there are a lot of people out there that you know will look at things that happened in the past and then they can use the data and they’ll go back and predict that they would have been able to buy Google when it first went public, or Amazon when I first went public.

Well you know of course they can say that because hindsight is 20/20, they would have been able to see that. Well, how would you how could you possibly even know that and think about you know the crash that just recently happened you know not a lot of people were able to predict that, and it came out of nowhere.

You know not to the people that were aware of what was going on but you know it was it was a pretty devastating blow to people’s 401ks their pension plans and everything. But if everybody had known it was going to happen then they obviously would have been able to you know to get out or protect themselves better than would have. Then what would have happened to them, so you know this one to me is a pretty self-explanatory bias. And it’s you know you have to protect, i.e., I guess the best thing that I would think of with the hindsight bias is you just need to be aware that when you look back at the history of things that have happened.

You know you have to learn from those mistakes, and you have to see what happened and try to project that forward so that you can see you know the types of things that could happen. And you know a great way to do that is you know Andrews book that we’ve talked about from time to time.

The value trap indicator you know he’s looked back at all the bankruptcies that have happened over the last period, and you know by using you know statistics he’sable to not predict every single one but pretty darn close.

And you know using that information he can project forward when he’s looking at a company that is going to invest in by using what’s

happened in the past. He can use that to help him avoid you know something that could happen to him in the future, and I think to me that’s where having an awareness of a hindsight bias can help you in the long run.

Andrew: Are you reading my mind because I was about to bring up hahaha maybe I think we’ve been doing this too long together so real quick like hindsight bias. It’s really easy to think that that you could be the one to sell right before a crash and buy right before a bottom.

Everybody has this sense that like all you know I would have been able to do it. But what I did in the book to illustrate this example was I took five random stock charts and my kind of basically I just put those on the page, and I said okay here’s what the stock price looked like for the past two-three months. Here here’s another one here’s another one here’s another would you buy here would you sell here would you sell here would you sell here.

And so I took you know to grab the type of charts you tend to see when it makes you feel bullish like you know if you see that nice chart where it goes from bottom left to upper right, and it’s just kind of like a straight line up. People like to see that and usually that they you know if they make it like the bullish case because I’ll look how strong it’s been lately.

And you know that goes into the recency bias, and then some people think that oh well it’s obvious that right at the top I should have sold here because it was going to be a crash afterward and then some other people say no well you should have you should have rolled it up indefinitely right.

So I took all those different charts, and it turned out you know I I explained that after the fact that look what the chart did beforehand had absolutely no relevance on what actually happened and to think that just from is looking at the chart that you can figure out when to get in it or out of the stock. It’s completely foolish, and it’s just it’s just completely random, and it’s not something that

you can you know your mind can think that you have this ability to be able to kind of time the market in away. And you know you might think in the future like oh you know I might have made a mistake that time, but I’ll get it right this time no that’s just hindsight bias really clouding your judgment.

And so I think that’s a real big reason why you need to have like I said for the first bias you want to have a system in place where your dollar cost averaging to combat this hindsight bias. I think you need to have a strategy where you have a specific sell strategy, and we’ve talked about this before episode 3 we talked about having a stop loss.

And we talked about how you know you can have parts of your portfolio with a stop loss and parts of your portfolio that hold stocks forever. And I went into that in detail in episode 3.

But you regardless of what you choose to personally do you need to have a specific sell situation that you know in your head that you’re not going to let your biases affect your emotions. Your brain and your perception and you know all these kinds of things that the mind can do make sure you have a system in place to counter that way you’re not compromising your performance. Because you’re tricking yourself into thinking that you can be the exception to the rule and be able to time the market

 

Dave: that is a great point and you know I think that you know timing in the market we’ve-talked about that before it’s a

fool’s game and it’s not practiced you want to get into.

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The next one we’re going to talk about is the confirmation bias, and I don’t know about you, but I have fallen into this one before. This is a bias that we do we seek out information that we believe true, and we use this as kind of evidence or facts to confirm our opinion and I’ll give you an example of something that’s happened to me with this many times I find a stock that I quote-unquote fall in love with and for whatever reason I read something about it that makes me intrigued by it and I think all this would be a great company to get into because I’m excited about the product that they sell or the management or something that just really gets me juiced about the company and then what I’ll do is you know as I start to analyze it.

I’ll start to discover things that are confirming what already think about the company and you know when I first started getting into investing I fell into this a couple of times, and I bought some stocks that I shouldn’t have bought.

And in hindsight you know again 20 20 you know I looked at you know what I did in my decisions and they were they were based on I was I was confirming what I always already thought I wanted to like the company and wanted to buy it.

And so I was looking for information I was going to confirm what I was already looking for and this could be a very very dangerous game to play.

You know Charlie Munger has written several times in several articles that he’s written that he talks a lot about destroying an idea. He doesn’t feel like he’s successful unless he destroys any of his ideas. And what he means by that is he’s going back, and he’s looking at so if he if he looks at stock a that he wants to buy he tries to figure out a way to tear it down.

And he figures that if he could tear it down, he’s tearing apart this confirmation bias because now he is looking at the company for what it is as opposed to having a preconceived idea.

About buying you know coca-cola not maybe not Coca Cola’s the best idea but you know it you get whereI’m coming from it’s it’s you know he’s helping destroy an idea and if he feels like he’s destroying that idea. It still comes out as a good idea that it’s a great investment. But you know if he’s able to you know not destroy it then it’s not a good idea because you know it’she’s just reinforcing what he’s what he wanted to do previously.

And to me, I think this is such a dangerous bias to fall into and it’s so easy to do it, and it’s it’s so easy to do with just about anything. You know if you think the weather is going to be bad, and you go in weather channel, and you see that the weather is going to be bad you’re just confirming what you think the weather’s going to be bad.

But then you go out, and it’s fantastic day so you know it’s just you know it’s it could be such a dangerous bias, and it’s something that we have to be aware of when we’reinvesting it’s almost like you put blinders on right

Andrew: yeah exactly you look at information, and you just see you see what you want to see exactly. It’s like this rose-colored kind of filter in there you know I think the big way to counteract this is to have a similar approach for every stock you’re looking at. So whereas you know with a confirmation bias you can kind of cherry-pick, and you know whoa okay well you know I like this ratio this month, and I like this ratio next month. Yeah, I think it is okay to have some variation, but at the end of the day, you want to have an approach that every consistent and if you’re analyzing stocks in a very similar way in January February March April May June I think that’s the best way to kind of combat this confirmation bias.

Because you ‘re still staying consistent and so when you have enough numbers, and obviously I love to be numbers based, you have enough of these numbers that are giving you the buy signals. Then you’re not going to have you know your chances of looking at the data and coming up with a different conclusion and having that conclusion be wrong.

Those chances are diminished when you’re consistent, and you stay with an approach that’s numerical and is based on fundamentals and principles that have been proven and that you’ll continue to use over time.

Dave: Exactly that’s that’s very very good point is being consistent in your you know analysis and your you know picking of the stocks and laying out how you want to have a process and you’re having a checklist and having you know you know a numerical system like Andrew has is just it’s a fantastic way to help avoid this bias I totally agree the next one we’re going to talk about is survivorship bias I ‘m going to have Andrew take a stab at that one first

Andrew: Yeah I did write an email about this one recently so this is more of an advanced thing when you start to become an investor who likes to look back at the past and try to take lessons from that and in the past so keep in mind with all these biases you know we talked about how looking in the past can really hurt you. It can’t you know so be aware of where it can hurt you.

But it can also be very beneficial obviously that’s how we get all of our lessons today and how we can build on the shoulders of giants by learning from what’s happened in the past. So what can happen and what a lot of investors do when they want to try to figure out you know where can I get an investing edge or how did a certain ratio perform or equation

They will use of back tests, and so well the back test does if anybody usually saw this not aware you take a group of stocks. You usually use some metrics kind of like a screener where you’re putting this criterion if stock fell in that criteria let’s say 10years ago now you track all the stocks that were in that particular criteria and you look ten years later to see how they performed.

the problem with doing aback test like that depends on where you get your data a lot of the companies that you know this might change in the future by the way, but as far as today 2017 a lot of these companies I provide this data do not keep the data of stocks that have already gone bankrupt.

And you know there think there is a service I wrote in my email, but it’s it’s extremely expensive, and it’s not practical for the average investor. So like if you are trying to do a back test with only stocks of survived, you’re not getting the whole picture you do not see the stock set you might have gone bankrupt or gone private and lost shareholders a lot of money.

so it might tilt these back tests up and make the results look better than they were.

Because basically though the way the description is it’s called survivorship bias, and you want to keep that in mind anytime, you see especially you know if you’re looking at media. Where it’s kind of like I don’t know like a mainstream media where the person you’re listening to might not be credible you know or might not be that experienced where they don understand back tests and the effect of survivorship bias on back tests.

Keep that you know any studies or data are the colds that are based on back tests. Make sure you look and see if they have accounted for survivorship bias because if they haven’t the data is likely. Useless it’s going to be incorrect data because it’s not accounting for the companies that didn’t-survive. And that has such a big impact on a decision you make because like you are saying excuse the numbers you know if there’s not you know something in there that could be so obviously negative and have an impact on you know the return of that particular sector or that particular company or even that particular you know the market.

You know that has a big impact on it especially if there’s a period where there were a lot of companies going bankrupt at that time I can have such a big impact. I know you wrote about that in your book and it seems like you know if I remember correctly there were a lot of those companies that went bankrupt were all kind of in a condensed period and if you look at a backtest during that period and those companies are not involved in that then that could really skew that period and make you make a and a judgement based on faulty information I guess is the best way of putting it

all right folks will that is going to wrap it up for us for tonight. I hope you enjoyed our discussion on biases and how they can affect our investing decisions.

You know the way we think there are some aspects of it that we actually can control and having an awareness of what some of these things are happening while they’re happening can help us control some of those thoughts. And help us make better decisions and that’s what we’re here to do is to talk to you about trying to make better decisions. And that was the what our discussion tonight was all about was trying to make better decisions and being aware of how our thoughts can affect us.

And if you want to learn more about I’m going to enter wrote a great article about some of these biases I’m going to link to that article also there is a great book that I would HIGHLY highly recommend it’s called Poor Charlie’s Almanac, and it was a compilation of Charlie Munger’s greatest thoughts she’s given some great speeches through the years. He also has some great articles, and they also have you know all kinds of great Munger isms, and it’s just a wealth of knowledge, and there are just so many great things and he’s very much expert in this field of you know the mental aspect of investing so I ‘d highly recommend you take it to check that out so without any further ado why don’t you guys go out there and find some good intrinsic value and best with a margin of safety emphasis on safety and have a great week, and we’ll see you guys next week

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