LESSON 3 – BEHAVIOURAL BIASES
The final topic I’ll discuss is related to psychology, and this is probably the hardest aspect to master.
In reality, it is far easier to digest the various economic theories and master the mathematics than it is to actually recognize and change your own behaviours. Fundamentally, humans are quite irrational and our decision making processes are often affected by a number of behavioral biases. Have a read through the list of biases on Wikipedia and see how many you recognize in yourself.
Loss aversion is an interesting one in both the financial and gambling markets. Somebody may claim that they are risk averse, when in reality they are ‘loss averse’, and actually take on more risk in order to avoid a loss.
There is an asymmetric relationship between how we react to losses and how we react to gains, such that we feel losses much more than gains. We see this manifest itself where people will keep a losing position open in the hope that it will turn around, but at risk of
making a larger loss, yet the same person will close a winning position early and lock in a reduced profit. I’m not necessarily saying that locking in small profits and risking large losses is always wrong, as things should be evaluated on a case by case basis, but behaviours such as this can distort and erode the value you find elsewhere.
Other biases to be careful of are overconfidence or optimism-based effects, and, if you spend too much time on gambling forums, the ‘fear of missing out’ which may lead you to over-trade, entering into questionable positions and again eroding value.
FINALLY – IT WILL GO WRONG!
Lastly, try to be aware of the probabilities and the real likelihood of both exceptionally good and exceptionally bad runs. We are very good at misinterpreting probabilities. The likelihood of losing a fair coin toss 5 times in a row is actually greater than 3%. If you have a large sequence of coin tosses (say 100), the likelihood of hitting 5 losers in a row gets quite large (I’ll leave calculating the exact probability as an exercise for the reader
It’s interesting that faked experimental data can be identified by the ‘absence’ of sequences like this. We massively underestimate the likelihood of bad runs and have trouble accepting them when they occur. They will happen and there is no point getting depressed about it.
Aim to construct your portfolio so that you can weather the bad runs, concentrate rigorously on finding value, try to be aware of any behavioural biases that may be affecting your decisions, and try to develop a Zen-like attitude to the randomness, and you will be well on the way to becoming a successful investor in both the world of sport or finance.