Loss aversion bias. Humans hate loss. They avoid thinking about it – this is dangerous. Aversion to loss in investing takes two forms.
Key points
- Bias is all around us and especially in investments
- Charisma bias is a dangerous form of bias
- Investing runs counter to human instincts
Take a company with a division that earns most of the profits and therefore drives the investment value. The bias tempts investors to focus on that even if the company also has bad divisions that can destroy value. This continues until it is too late and the bad bit has rendered the investment void.
Another form of loss aversion is preferring to avoid losses rather than make gains. This is why investors run losers and sell winners. You run a loser because you can not face up to the fact that you have had a loss. You hope for the best and because the loss is not crystallised you yearn for the day when you can sell at a profit.
One way to avoid this is to consider, ‘is loss aversion causing me to think differently about this company than if I wasn’t in a loss position?’.
That way you should be able to spot when you are fitting the facts to your reluctance to take a loss, rather than looking at them dispassionately.
Representativeness bias. This is when an investor infers too much from a small amount of information. Think of a shop that heavily promotes one item and thereby gets an unwarranted name for cheapness, that is representativeness bias.
For investors, extrapolating narrow assumptions is much more costly. Years ago we looked at a gaming business called Bwin.Party and then bought shares.
The UK market for Bwin was mature, regulated and (as we found out later) unlike every market that developed after it. We studied it carefully. But unfortunately we underestimated just how different the other 10 markets would become.
This and other headwinds meant that while we expected a more than doubling of revenues over three years, in fact, we were handed a small decline.
Avoid this by going back over your analysis and checking if you are basing your work on the extrapolation of a small sample.
Pot committed
Endowment bias is when we endow an asset with too much value because we own it. We humans view something that we own differently than if we didn’t own it. In other words, the problem for an investor is it makes it harder to sell and move on when the news is bad. If you did not own it, you would see bad news as bad news, but if you do own it, you make excuses.
