15 biases that make you a bad investor

Investing shouldn't be hard. Buy quality companies at good prices and hold them for a long time. Not much more to it than that.

Yet so many investors — maybe most — fail to beat a basic index fund.

Why?

Blame your brain. We come hardwired with all kinds of biases that cause us to misinterpret information and push us into regrettable decisions. Here are 15 of the biggest.

Confirmation bias
Starting with an answer, and then searching for evidence to back it up.

If you start with the idea that hyperinflation is imminent, you'll probably read lots of literature by those who share the same view. If you're convinced an economic recovery is at hand, you'll probably search for other bullish opinions. Neither helps you separate emotions from reality.

Berkshire Hathaway (NYSE: BRK-B) vice-chairman Charlie Munger is a fierce advocate of the intellectual strategy of Charles Darwin, who regularly tried to disprove his own theories, and was especially sceptical of his own ideas that seemed most compelling. The same logic should apply to investment ideas.

Recency bias
Letting recent events skew your perception of the future.

When we're in a bull market, you think it'll last forever. When we're in a recession, you think we'll never recover. After a banking crisis, you think another is right around the corner. Rarely is that actually the case — it's usually the other way around — but it's what feels right when memories are fresh in our minds.

Backfiring effect
When presented with information that goes against your viewpoints, you not only reject challengers, but double down on your original view.

Voters often view the candidate they support more favourably after the candidate is attacked by the other party. In investing, shareholders of companies facing heavy criticism often become fanatical, die-hard supporters for reasons totally unrelated to the company's performance.

Anchoring
Letting one piece of irrelevant information govern your thought-process.

Best example: Investors anchor to the idea that a fair price for a stock must be more than they paid for it. It's one of the most common, and dangerous, biases that exists. "People do not get what they want or what they expect from the markets; they get what they deserve," writes Bill Bonner.

Framing bias
Reacting differently to the same information depending on how it's presented. Example:

"Google shares surge to highest level in five years."

"Google shares haven't gone anywhere in five years."

Both statements are true.

Skill bias
When education and training causes confidence to increase faster than ability.

The best example is the hedge fund Long Term Capital Management. Staffed thick with PhDs and two Nobel laureates, the fund exploded in 1998 under an incomprehensible amount of leverage. Behind the failure was raging overconfidence. "The young geniuses from academe felt they could do no wrong," Roger Lowenstein wrote in the book When Genius Failed.

Warren Buffett said this about the firm's sixteen-person management team:

They probably have as high an average IQ as any sixteen people working together in one business in the country … just an incredible amount of intellect in that group. Now you combine that with the fact that those sixteen had extensive experience in the field they were operating in … in aggregate, the sixteen probably had 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor: that most of them had virtually all of their very substantial net worths in the business …And essentially they went broke. That to me is absolutely fascinating.

Hindsight bias
Out of literally millions, only a handful of investors truly saw the financial crisis coming.

If you disagree with that statement and respond, "No, any idiot could have seen it coming from a mile away," you're suffering from hindsight bias. Only after the fact do all the puzzle pieces make sense. That's why bankruptcies outnumber billionaires.

Pessimism bias
Underestimating the odds of something going right. Financial advisor Carl Richards writes:

We focus so much on protecting ourselves from negative surprises (job loss, disability, divorce, death .. the whole catastrophe) that we forget to factor in the positive ones (a raise, a business that works out, a new career, a new bull market) that can sometimes change our entire outlook.

Halo effect
"If we see a person first in a good light, it is difficult subsequently to darken that light," writes the Economist.

Mutual fund manager Bill Miller beat the S&P 500 for 15 years in a row — one of the best track records ever. He became, and largely remains, an investment legend.

Yet Miller's flagship fund fell so hard over the last few years that his career-long track record just barely squeezed by an index fund. Jason Zweig of the Wall Street Journal wrote last year: "Over the full stretch since Mr. Miller became lead manager of the fund in 1990, he has gained an average of 9.39% annually, versus 9.14% for the S&P 500."

Does this hurt his reputation? Yes. But not as much as you might think. Despite a distinctly mediocre long-term record, I suspect Miller will always be remembered as a legendary investor.

Illusion of control
Thinking that your decisions and skill led to a desired outcome, when luck was likely a big factor.

If you've ever made money day trading and patted yourself on the back for a job well done, you're probably a victim of the illusion of control.

Escalation of committment
The classic "throwing good money after bad."

Doubling down on a plunging stock, not because you believe in its future, but because you feel the need to make back losses. Happens all the time at blackjack tables, too.

Negativity bias
Assuming perpetual doom, that problems will never be fixed, and that all hope is lost.

This bias has been rampant for the last four years, and has caused many to forgo investing opportunities of a lifetime.

Ostrich bias
Ignoring reality when it's screaming in your face, usually in an attempt to rationalise a certain viewpoint.

Great example: A recent survey of 1,000 investors showed an average of more than half of respondents said the market declined in each of the last three years. But it didn't. The S&P 500 rose 26.5% in 2009, 15.1% in 2010, and 2.1% last year. Pessimism trumped reality.

Risk perception bias
Attempting to eliminate one risk, but exposing yourself to another, potentially more harmful, risk.

Here's an example I've written about before: In the year after 9/11, air travel fell, and car travel jumped. Understandably, people suddenly felt planes were more dangerous than cars.

But statistically, the opposite is true. In his book The Science of Fear, Daniel Gardner notes that if there were a 9/11 every day for an entire year, the odds that you'd be killed by terrorists are one in 7,750. By comparison, the annual odds of dying in a traffic accident are one in 6,498. German professor Gerd Gigerenzer estimates that the increase in automobile travel in the year after 9/11 resulted in 1,595 more traffic fatalities than would have otherwise occurred. Add in the impact stress had on our health, and the reaction to 9/11 may have been more deadly than the attack itself. "People jump from the frying pan into the fire" said Gigerenzer.

Today, an untold number of investors are choosing the perceived "riskless" safety of bonds trading at record high valuations, because they don't want the risk of volatile stocks. Ten years from now, there's an uncomfortably high chance they will be victims of risk perception bias. From the frying pan of stocks right into the fire of bonds.

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