Investor Biases

MarketSmith India_ Investor Biases Article

“Don’t argue with the market. Never try to prove you’re right and the market is wrong.” – William J. O’Neil, MarketSmith Founder

In the last week’s learning article, we discussed how a rules-based investing system helps an investor to stay clear of biases. Biases can be of two types: cognitive biases, which stem from faulty reasoning, errors in processing information, and memory errors; and emotional biases, which arise from emotions rather than any conscious thought. Between these two types of biases, cognitive biases are easier to correct, through understanding one’s mistakes and learning from them.

Today we will delve deeper into two very similar types of cognitive biases, which can significantly affect one’s investing decisions.

1. Conservatism Bias: This is a case in which a rational view or decision is initially made; however, the investor fails to change that view, once new information is available. Let me give you an example of this bias. The Australian cricket team was the best international team in the sport from 1999 to about 2008 or so. At that time, many prominent players retired, and in another two years’ time, the team was vastly different, with many new players in the side. Now, if a fan of the Australian cricket team believes that the team would continue to be the most dominant one, without having a thorough look at the new players, then that cricket fan is exhibiting conservatism bias.

2. Anchoring and Adjustment Bias: In this case, the investor changes his views based on new information, but the changes are made in relation to the initial view, and hence the changes are inadequate. Assume that you are a frequent passenger in a train that is always running late. One day, you check a railway mobile app, and see that the train is running on time, with only a couple of hours to reach your station. Now you think that the train will reach your station earlier than usual, but behind the scheduled time, since it has always been running late. This would be an example of anchoring and adjustment bias.

Now that we have understood these biases, we will look at how they affect an investor’s decision making, and how the CAN SLIM method can help you stay on the right track.

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