“Sky is the limit” probably does not apply to markets nowadays! The relentless upward trend in equity prices seem to suggest that markets have forgotten that there even exists a sky!

The following chart best describes the emotional state at various stages of market cycle and it seems to me we are treading some where between thrill and euphoria.

Why is it that as we reach peak of market cycle, we are at a point of maximum financial risk? Assuming there indeed is a ceiling to how much prices can grow, as prices move upwards, the marginal future gains decrease, or put it another way, the chance that price will further increase by X % becomes smaller than the chance that price will decrease by X %. This asymmetry in the likelihood future possibilities manifests in the form of financial risk!

In times like these, I think the best posture is to be cautiously optimistic and be mindful of intrinsic cognitive biases that could hurt our future portfolio returns.

In the spirit of being mindful of my flaws, in this article, I want to summarize the list of top-5 cognitive biases that I have suffered from at one point or the other in my investing career.

Loss Aversion

The basic idea of lose aversion is that loss hurts more than the pleasure derived from gains. This idea was first systematically studied by the Noble prize winning author, Daniel Kaneman with Amor Taversky in their seminal paper, “Prospect Theory: An Analysis of Decision under Risk.

The following thought experiment nicely illustrates the intrinsic bias for loss aversion: given a choice of receiving $950 vs. throwing a two-outcome dice with 95 % chance of winning $1000, most folks would prefer collecting $950. Alternatively, for the choice of losing $950 vs. throwing a two-outcome dice with 95 % chance of loosing $1000, most folks will choose the later option.

I have suffered from the loss aversion bias several times in my investing career. The most striking example was my investment in ticker: NOV in late 2014. I held onto my NOV position through losses until end of 2016 even when I was strapped for cash for a high conviction investment in APPL, when it dropped to $93 a share, in summer of 2016.

Disposition effect, a phenomenon that I touched upon in my last article, is a related concept, which leads investors to sell winning position and hold onto a losing position. More than loss aversion, disposition effect has caused me significant pain throughout my investing career to a point that I am now making a conscious effort to recognize this bias whenever it surfaces in my decision making process. Some examples, I bought CMG at $252 only to sell at $525, bought AAPL several times under $100, only to sell whenever stock crossed $150. Buying FB at $20 only to sell at $50, buying MSFT at $33, only to sell at $52 and more recently my speculative bet in PCG, purchased at $3.46, only to sell at $7.09.

Familiarity Bias

Familiarity bias is a rather common bias suffered by most folks in the investing community. Examples include, portfolio tilted towards home country stocks, or having excess concentration in employer stocks, resulting in under-diversification.

I am guilty of this bias, and I really do not know how to over come it. I am most familiar with US markets and also have the conviction that it is futile to bet-against the US in the long-run. My equity holdings are therefore extremely skewed towards US listed companies. Also at present, I am heavily concentrated in my employer stocks. This stems from my conviction that my employer stock are trading at a discount to fair value.

I do not presently have a solution to overcoming familiarity bias, but being mindful of this bias in my portfolio is a step forward in the right direction.

Anchoring

Anchoring bias is most obvious when it comes to negotiating the price of a transaction. In markets where haggling is the norm, use of anchoring bias can be beneficial to getting an upper hand on the negotiation. Its a common technique employed by pretty much every road-peddler in India. The idea is if I want to sell (or buy) something, I should mark the price up (or low) to some inexplicably high (or low) value, fully expecting the other party to negotiate. By setting a high selling price (or low purchase price) at the start of the negotiation, one creates an anchor and forces the other party to make a counter offer, that could still be well above the price the selling party is willing to accept, and at the same time creates a sense of a win-win situation where by the buyer also feels happy about the transaction.

In investing anchoring can be hurtful, especially when trying to purchase a stock. I have suffered from anchoring bias several times, when I am anchor myself to a purchase price putting in a limit purchase order, a few cents below the current market price for the equity. I end up not purchasing the stock, only to later see the stock increase 5 % 10 % above my limit price.

Gambler’s fallacy

Gamblers fallacy is an erroneous belief that if a particular series of events have happened more than normal in the past, it is less likely that they will continue to happen with increased frequency in the future. To put it concretely, if we flip a fair coin 5 times and get HHHHH, what is the chance of getting a H again? Right answer, H, these are independent trials. However Gambler’s fallacy would give a higher likelihood for T to appear on the 6th flip of a fair-coin.

Gambler’s fallacy may be playing out in real-time in todays markets. My last post, titled “Retrospection“, may in some sense be an indicator of Gambler’s fallacy playing out.  I came across a recent post by Nick Maggiulli, on his blog, titled “The Investor’s Fallacy“, which sheds some light on this idea.

I may be suffering from this fallacy, in my stance as a cautiously optimistic investor in the current market environment. However, again as with Familiarity Bias problem, I do not have a good answer to remedy this bias in my investing approach.

Attention Bias

Attention bias plays out quite often in investing. A study by Brad Barber and Terrance Odean, found that investors tend to purchase rather than sell shares of stocks that have garnered their attention. A rationale behavior would be to assign equal probability to buying and selling of a stock that has for whatever reason has come on investors radar.

Attention bias is quite prominent in my investments. Almost all stocks that I have purchased have come on my radar through some form of news! I do not remember any selling that I have done based on attention to news about the stock. It may be that I look for bad news, and my contrarian instincts, perceive good long term opportunity to buy and when I see good news, I do nothing, given I am a long-term buy and hold investor.

I am taking steps to take note of this bias and I believe of all other biases, attention bias could be the one that I can fix as I continue on into my investment journey.

Video/Book/Article/Audio for the Week

• Video: Why Own Berkshire Hathaway?  Gregory Warren, Morningstar analyst digs deep into reason why it totally makes sense to own Berkshire now
• Video: Classic Charlie Munger video on The Psychology of Human Misjudgement. I had seen this video a few years back and saw it again this past week, as I was thinking of my own cognitive biases.
• Article: Behavioral Economics’ latest bias. This is a fascinating Bloomberg article, almost a pun on biases, i.e., what happens when behavioral economics, a field that studies cognitive biases, itself is biased!
• Blog: Nobody feels Overpaid. A interesting short blog by Michael Batnick of Irrelevantinvestor.com, on the state of employment markets of today when even a million dollar salary can make you grimace about not being compensated well. I personally have an opposite problem. I do feel overpaid for my contributions to the firm and society, a symptom of imposter syndrome?