QUALIPORT
The Common Mental Mistakes Investors Make

By Maynard Paton (TMFMayn)
September 21, 2004

"Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ... Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." -- Warren Buffett

Becoming a successful investor involves battling with basic human nature. Almost all of our evolution as a species has revolved around living in caves, fighting for survival and hunting for food, none of which has prepared our brains well for dealing with volatile financial markets.

US Fool contributor Whitney Tilson recently listed the following as the most common mental mistakes amongst investors:

• Overconfidence;
• Herd-like behaviour (social proof), driven by a desire to be part of the crowd or an assumption that the crowd is omniscient;
• Projecting the immediate past into the distant future;
• Misunderstanding randomness; seeing patterns that don't exist;
• Commitment and consistency bias;
• Fear of change, resulting in a strong bias for the status quo;
• "Anchoring" on irrelevant data;
• Excessive aversion to loss;
• Using mental accounting to treat some money (such as gambling winnings or an unexpected bonus) differently than other money;
• Allowing emotional connections to over-ride reason;
• Fear of uncertainty;
• Embracing certainty (however irrelevant);
• Overestimating the likelihood of certain events based on very memorable data or experiences (vividness bias);
• Becoming paralysed by information overload;
• Failing to act due to an abundance of attractive options;
• Fear of making an incorrect decision and feeling stupid (regret aversion);
• Ignoring important data points and focusing excessively on less important ones; drawing conclusions from a limited sample size;
• Reluctance to admit mistakes;
• After finding out whether or not an event occurred, overestimating the degree to which they would have predicted the correct outcome (hindsight bias);
• Believing that investment success is due to wisdom rather than a rising market, but failures are not their fault;
• Failing to accurately assess their investment time horizon;
• A tendency to seek only information that confirms their opinions or decisions;
• Failing to recognise the large cumulative impact of small amounts over time;
• Forgetting the powerful tendency of regression to the mean, and;
• Confusing familiarity with knowledge.

The Qualiport's has probably been guilty of most (if not all) of these 'caveman' mistakes at one time or another.

Looking back, 'projecting the immediate past into the distant future', 'forgetting the powerful tendency of regression to the mean' and 'herd-like behaviour' were among the reasons why the portfolio lost money on Dell Computer (Nasdaq: DELL), Lloyds TSB (LSE: LLOY), Marks & Spencer (LSE: MKS), MMT Computing, PizzaExpress, Rentokil Initial (LSE: RTO) and Unilever (LSE: ULVR) over the last seven years.

Though the Qualiport's performance has improved over time, the following pitfalls from Whitney's list will be the hardest for this portfolio to avoid:

Fear of making an incorrect decision and feeling stupid.

This fear is particularly acute for public portfolio managers. The Qualiport can't hide its trades and has nowhere to run as and when its holdings disappoint.

If some of the portfolio's shares suffer sharp price falls, there's a danger the Qualiport will not sensibly average down at cheaper prices. Instead, the portfolio could sit on its hands to avoid the possibility of watching the shares fall further, losing more money and appearing rather foolish.

Commitment and consistency bias.

After buying a share, human nature has the nasty habit of making us more confident it will rise. This phenomenon also causes us to seek out information that confirms our opinions or decisions.

A share purchase also forms a commitment. When the facts change for the worse, human nature will still tell us to hang on, since nobody likes to face up to their mistakes (and scrap a lot of investment research).

By declaring that shares are picked for the long term, the Qualiport has made a commitment to buy and hold. Consistency could see the portfolio remain in denial and keep the faith with any losers for far longer than necessary.

Confusing familiarity with knowledge.

The Qualiport has now become very familiar with quite a few firms. Emap (LSE: EMA) for example has been in the portfolio since 1998 and many shares have been monitored since the watch list's inception three years ago.

But familiarity breeds short cuts. Because a company has performed well in the past, there's every chance of complacency setting in, overlooking recent developments at portfolio companies and basing decisions on yesterday's 'knowledge'.

Summary

Investors will always succumb to the mental mistakes detailed within Whitney's list. However, maintaining a strict and straightforward strategy should limit the damage. Once a set of firm share selection criteria is in place, there's less chance of straying off and succumbing to good old human nature. Trouble is, most investors only get to form their winning strategies after learning how their Neanderthal instincts can wreak havoc on a portfolio!

More: Big Investing Mistakes

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