Humans are emotional creatures, which separates us from machines and computer programs powered by AI. In investing, having emotions naturally leads to us having certain investing biases.
Unlike us, bots have the “discipline” or “ability” to buy or sell a stock when it hits certain pre-set limits. As emotional beings armed with the capacity to do whatever we want, being able to buy or sell a stock as logically as we can elude us. Despite our best efforts, our biases may be inherent and lead us to make irrational decisions even if the facts are bare.
Some common investing preferences include oversimplifying things, confirmation bias, information bias, incentive bias and loss-aversion bias. Many factors may trigger a bias. For instance, if you fear losing money, you are less likely to cut your losses even though the stock’s fundamentals have worsened.
This is unfortunate regarding investing, as the vital trait here is discipline. Investing is also like a game of knowledge. Whoever has more of it will win more in the long run. Your goal as an investor is to be as impartial as possible, and this is doable these days, as information — such as annual reports — is now more easily accessible. Here are a few common biases and ways to overcome them.
Bet on what you know
What we consume determines the type of life we live. Likewise, what you consume makes you the kind of investor you are. In this case, it is essential to put a larger or greater weightage on facts rather than opinions for what you read and invest based on your consumed information.
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For instance, if you are working in the healthcare sector and are familiar with more names in the industry, reading a 10-minute article by any author recommending any healthcare stock may lead you to buy a name you recognise and consume in your daily interactions.
While being familiar with the sector is a good thing, this may lead you to skip doing actual research on the stock itself, which is a fundamental error.
Listen and learn
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As with everything in life, research is necessary. This means you should not just buy or sell a stock based on the information given by people you trust, such as a colleague or a celebrity.
In the case of the meme stock frenzy that took the markets by storm in 2021, stock prices for specific counters surged thanks to retail investors who deemed them popular via social media. When many invest in a particular stock or sector with no intrinsic value, this causes a bubble. And we all know what happens when the bubble bursts.
There is always a reasonable price range for anything and everything, and investors should be wary of overpaying for a stock, even though it may seem attractive to everyone else.
Find what works for you
When investing in any stock, you must value the stock as impartially as you can. If you go by fundamental analysis, you should not have a vested interest in the stock for no good reason.
A vested interest can happen if you spend too much time reading up on the stock rather than listening to other viewpoints. While this may contradict our point, we advocate for balance here. You should be open to sound criticism or opinions and consider the advice if it makes sense.
Your job is not to shut out other opinions. You want to see whether said opinions will affect your valuations. Ultimately, your goal is to find a good stock and understand the risks of the stock better. Admitting that your thesis was wrong can go a long way in achieving success.
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There is no perfect formula
While looking at historical records to understand how the company has performed so far is good, people tend to focus on the company’s good performance and underweight the same company’s lousy performance.
In their view, the good times will usually continue, and the bad times will not. For example, suppose the company has a good record of profits and growing revenue for 10 years and made losses for a period after that. In that case, people tend to believe that the profits will return based on historical data.
This is untrue. You will still have to look at the trends, the company’s financials, economic trends, and lifestyle trends of the company. While historical performance should be considered, consistency and results are not guaranteed. No one knows what will happen.
Take the tech sector, for instance. During the last two to three years, share prices of tech stocks have soared exponentially. Yet three notso-fine quarters later, the prices have slumped for various reasons.
On the flip side, you should not generalise the sector either. Again, using the tech sector as an instance, the dot-com bubble in the late 1990s saw more than a few Internet companies crash.
Still, some companies have made excellent returns if you invest in them. Using Google as an example, shares in its parent company, Alphabet, had a decent cash flow in the early 2000s. However, the share price is now over 3,200%, up from its initial share price of US$2.71 in August 2004. This is not even at the company’s peak.
Prepare for changes
As you research, you ought to approach this exercise with humility. You need help understanding the stocks you have invested in, even after reading 10 annual or industry market reports.
The more important thing here is to understand your investments. Sometimes, circumstances may change. For instance, questions to ask yourself include:
- What drives the company’s profits and revenue?
- Is the business of the company seasonal?
- How does the company make its cash?
Different businesses operate on various metrics: For instance, watch out for the free cash flow in the cash flow statement of a company’s financial report. After this, look at the company’s expenditure. Every company’s expenses differ depending on the nature of its business. You will want to understand how the company gets its cash after deducting everything — capital expenditure (capex) and operational expenditure (opex) included.
Even if you can understand a company’s financial statements but do not get its products and services, this does not count as genuinely understanding it enough to put your money into it.
