Fallacies and Biases Investors Must Guard Against

A fallacy is defined as a mistaken belief based on faulty reasoning. A cognitive bias is a systematic error in thinking based on faulty reasoning or on failing to apply sufficient reasoning – in other words, by taking a mental short cut. Fallacies and biases are unhealthy for investors, who have succumbed to them since the dawn of time.

A variety of human factors get in the way of lucid reasoning, including emotions, attitudes, preconceptions, and simple mental laziness. In investing this can lead to a distorted or unrealistic assessment of investment reward and risk.

Here are some common fallacies and cognitive biases that ensnare investors and which you need to guard against.

Fallacies

Maria Konnikova, a Russian-American writer, speaker and professional poker player with a PhD in psychology, gave a fascinating presentation a few years ago at the Allan Gray Investment Summit. She identified two fallacies that gamblers – and investors – are prone to believing:

• Gambler’s Fallacy: If you flip a coin and it lands heads five times in a row, is there an improved chance that on the following flip it’ll land tails? The answer is no: it’s still 50-50, because each flip is an independent event, and events don’t have a memory. If you answered in the affirmative, you have fallen for what is known as the Gambler’s Fallacy, whereby a gambler on a losing streak feels sure his luck is about to turn. Conversely, gamblers on winning streaks are often confident that their luck will continue. Note that in both instances the gambler (or investor) believes the outcome will be positive.

• Sunk Cost Fallacy: Related to the above, this is when you have sunk so much of your time, energy and/or money into an investment or project that you cannot bear to bail out and cut your losses. It is why investors, businessmen and even governments regularly throw good money after bad. And conversely, it is why meteorologists, who are not personally invested in a particular outcome, tend to make relatively accurate weather forecasts, Konnikova says.

Biases

In his seminal book, “Thinking, Fast and Slow”, psychologist Daniel Kahneman identified a number of mental traps and biases, which are particularly relevant in money matters.

• Statistical biases. When presented with statistical information – for example, graphs of share prices – we often see patterns or attribute causes where none may exist, tending to underestimate the degree to which randomness plays a role. We also tend to confuse correlation with causation. For example, the decline in both stork populations and human birth rates in Europe show a high correlation, but no clear-thinking person would use it to support the myth that storks deliver babies.

• Availability bias. Our decisions and views are influenced by how easy it is to retrieve information from memory, or how “available” the information is. A good example is news broadcasts on TV or radio, which focus on bad things such as wars and famines. Dramatic events are more likely to stick in our memory than mundane ones, leading us to think the world is a more dangerous place, or the economy is in a worse state, than it may actually be.

• Regression to the mean. Luck contributes more to success than we give it credit for. If a fund manager performs well, investors are more likely to attribute the superior performance to the manager’s skill than to luck. However, the probability is high that the fund manager will perform less well (reverting to average performance) in the future, just as a manager who has performed poorly is likely to perform better in the future.

• Loss aversion. Research by Kahneman and his colleague Amos Tversky found that people experience the pain of a loss more intensely than the pleasure from an equivalent gain, leading them to prefer avoiding losses over acquiring gains. They found that most people would accept a “gamble” only if the expected gain was at least twice as big as a possible loss. “This asymmetry between the power of positive and negative expectations or experiences has an evolutionary origin,” Kahneman says. “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”