A thread on Behavioral Biases from the book The Joys of Compounding

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Behavioral biases affect every investor's decisions Recently re-visited the excellent book The Joys of Compounding by @gautam__baid A 🧵 on my key takeaways from Charlie Munger's Psychological Checklist of the Standard Causes of Human Misjudgement #CharlieMunger #investing

Bias from mere association We humans, connect an incident as a stimulus for pleasure or pain. Example: If a FED rate hike resulted in market correction in the past & subsequent portfolo fall, then every FED meeting is a viewed as a painful situation and leads to panic.

Understimating the power of rewards and punishment People repeat actions that resulted in a reward & avoid those that caused punishment, even if it was a result of pure luck. Example: Investors stick to the winning strategy forever, ignoring that the facts have changed.

Underestimating bias from one's own self interest & incentives We want to see the stock of the business we invested in, to go up. This makes us buy even when a deterioration in fundamentals corrects stock price. Self interest makes us believe that the business will do well.

Self-serving bias An investor credits success in a particular investment is accorded to his stock picking skills. While failure is accorded to external factors & events. This bias makes an investor turn a blind eye towards his mistakes & knowledge gaps.

Self deception and denial People distort reality by engaging in wishful thinking & what-if scanarios that aren't a reality. Example: Often we extrapolate bull market returns in the future to calculate our networth. This leads to incorrect investing decisions for the future.

Consistency bias & commitment tendency To maintain continuity & stick to our conviction, we ignore any negative info about the business. We look for data that supports our hypothesis. Commitment to past beliefs stems from inability to: ~ Spot errors ~ Course correct

Bias from deprival syndrome. Humans respond to immediate threats of scarcity. We await a certain business to come into our buy range. However, a sudden uptick in price, creates deprival syndrome. We feel we may never get even the current price & buy at a high price.

Status quo bias & do nothing syndrome Humans are wired to be lazy. Too often, we clearly see business fundamentals deteriorating. However, we don't investigate the cause & hope for things to improve. Laziness to track business progress could lead to losses beyond recovery.

Impatience We have researched & built conviction in a business & have bought a sufficient position. But we are impatient to realise profits quickly. Every other stock that is giving good returns adds to our impatience, often resulting in selling at the wrong time.

Bias from envy & jealousy. This bias is the chief reason why we spend on unnecessary things. Jealousy towards our better off relatives/neighbour makes us spend unnecessarily/ take debt to: ~ Match their lifestyle ~ Show off our wealth

Distortion by contrast comparison We overlook gradual quarter-on-quarter progress made by a business but notice the good performance on seeing a comparison with it's rival. On the flip side, we fail to notice worsening fundamentals and realise only when we see a rival do well.

Bias from anchoring We hold certain benchmarks in our mind, that influence our investing decisions. The initial buy price serves as an anchor point, and we fail to increase our position size above the buy price. This bias makes us feel the stock as costly.

Overinfluence from vivid & recent events Also called recency bias. Immediate past have a bearing on current decisions. In bull run, investors forget pain of past corrections & repeat the mistake of buying low quality. Vividness of rising market influences investor's mind.

Omission & abstract blindness We hear success stories of people getting rich quick in stock markets. We don't know & neither do we look for the ones who failed & became bankrupt. This missing information, is why many youngsters still enter the market for the wrong reasons.

Bias from reciprocation tendency We return the favors that we have received. To help a friend, we share our portfolio stocks as reciprocation. However, we give little thought to his risk profile & risk taking ability. This can prove disastrous for the friend & the friendship!

Bias from overinfluence by liking tendency We tend to agree with stock picks & opinions about a business by person who inspires you. Your close friend or a colleague so much that we value the person more than his argument.

Bias from overinfluence by social proof Humans tend to imitate others. The excitement about an IPO, makes us excited too. This is the major driver of FOMO ( Fear of Missing Out) during a bull market. Since everybody else is making money, we buy anything at any price.

Bias from overinfluence by authority A veteran investor buying a certain stock or speaking good about it makes us believe the stock is good. We ignore our own research & blindly put faith on the expert. Portfolio cloning strategy is highly susceptibel to this bias.

Sense Making We fit a story around the outcome & think that we could have predicted the outcome beforehand. Hindsight basis stories always appear obvious. In a similar situation in the present we can't take same decision since the benefit of hindsight is absent.

Reason respecting We believe arguments that are supported with a reason. If we're presented with data, as to why a business is bad we believe it, without self concluding from the data. We respond to what we feel (in this case, we feel informed) rather than what we understand.

Believing first & doubting later In a distracted state, when focus & attention is scarce we end up believing things. The reasonsing mind doesn't evaluate the data. Too often a heavily advertised brand seems moat of a business. Once we actually study it, we start to doubt it.

Memory limitations Mind remembers only selective information. Often a sequence of events linked more by imagination rather than actual fact. This bias causes investors to forget salient points about a business & remember the ones that are highlighted by the management & media.

Do-something syndrome Restlessness leads to this situation which ends up in knee jerk decisions, just to take some action. Salary in bank account, often gives birth to this syndrome. People are tempted to trade or put money behind stocks whose business have no value.

Mental confusion from say something syndrome We feel obliged to speak, even when we have no idea what to speak. Managements in concall are expected to answer every question & sometimes respond vaguely. An investor shud distinguish between genuine answers & vague replies.

Emotional arousal Intense emotion make us take forced decisions. Deep corrections make people panic & exit quality stocks in hurry. News about investor's losing crores in market crash fuels this bias. We are emotionally aroused on hearing negative commentary about a business.