Our brains sabotage our investing
Ken Heebner, who ran CGM funds from 1968 to 2016, was a legendary fund manager known for taking gutsy contrarian calls. For over a decade, his fund, CGM Focus returned +18.4% annually, beating the nearest comparable fund by 3.4%. Exceptional over such a long time period.
An analysis of investor returns in the fund, dollar-weighted returns taking into account capital flowing in and out, showed the typical investor lost 11% annually! i.e. -11% from a fund returning +18%!
Think about that why that might be. The typical investor bought into the fund right after it had a strong run, then sold, when it saw a significant decline, the opposite of ‘Buy low Sell high’.
Success in investing is 15% about picking the right investments and 85% about being aware of the cognitive biases that could sabotage the potential returns from those investments
Since the time behavioural economics as a distinct field of study was made popular by Daniel Kahnemann and Amos Tversky, hundreds of cognitive biases have been identified and labeled.
This is an evolving compendium of the most frequent biases that we, as investors are susceptible to. Each post has a short explanation of the bias, how and why it affects us, and what we can to innoculate ourselves from it. If you see any missing, drop me a note.
The definitive list of Investor Cognitive Biases
Neglect of Probability: Our brains consider a one-in-a-billion lottery ticket and a one-in-a-thousand shot at a 10x return from a stock to be the same thing
Scarcity Error: What is valuable is rare, therefore what is rare (or seemingly so) must be valuable
Survivorship Bias: Why you should read biographies for entertainment, not learning
Moral Hazard / Incentive Super-Response Tendency: To understand why people do what they do, understand their incentives. And the one question you should ask any advisor
Regression to the Mean: This powerful concept implies successful value investing depends on not just picking stocks trading at low Price-Value metrics but whether they have underperformed after a period of outperformance
Narrative Fallacy: Our brain’s tendency to neatly arrange all information into cause-and-effect makes us susceptible to buying into questionable investment stories
Sunk Cost Fallacy:
Availability Bias / Recency Effect
Chauffeur Effect (Don’t take News anchors seriously):
Groupthink / Social Proof Effect:
Reference: The Better Humans blog has a neat graphic for these biases.