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Psychology of Biases – Part 3: The last two of the main culprits

Biases

Part 1 and Part 2 of this series covered six predominant investing biases that I’ve noticed over my years and research as a wealth manager: overconfidence, social proof, pride and regret, the halo effect, considering the past, and the illusion of diversification.

We’ve got two more to go! Last, but certainly not the least, are representativeness & familiarity, and scarcity. Together, being aware of these eight biases will help you invest smart and make some money along the way.

Representativeness and familiarity (the home country bias)

It’s no surprise that we gravitate to what we know, and have the tendency to shun things that are new, different, and unfamiliar. In investing, this phenomenon is referred to as the home country bias where investors lean heavily on securities in their home country. It’s partially due to how often they encounter them or their products in everyday life.

This bias occurs in countries of all shapes and sizes, but can be less problematic for investors who live in countries with well-diversified markets. However, it has been atrocious for places like Greece where investors owned a majority of their equity investments in their home market before the financial crash. This has also happened in Japan in the 80s and 90s — decades later, the Japanese stock market is still down considerably.

Canadians, too, are not immune to the home country bias and have a disproportionate percentage of their investments in Canada. Sure, Canada may have great stock market returns in the years to come, but do you really want to bet your retirement on it? Keep in mind a significant portion of our economy is based on commodities whose prices are determined by international markets.

The home country bias transcends national borders as well. People who live in Atlanta and Waterloo have portfolios that are comparatively over-weighted in Coca-Cola and Blackberry, respectively, as their head offices are located there. Investors also tend to invest heavily in the industries in which they work. Not only are they more familiar with the companies, but they also feel their industry experience gives them an advantage over the average investor — which usually isn’t nearly as significant as they believe.

Suggestion: When building your portfolio, try not to think of yourself as a Canadian investor, but rather an investor with no fixed destination and without a country of preference.

Scarcity

Scarcity is one of the most powerful tools advertisers and businesses use to get your attention. Growing up I had a limited understanding of this concept — it was usually apparent after waiting an hour to get into an empty club or being persuaded by commercials announcing “limited time offers”. I fell for it every time.

That changed when I read Influence by Richard Cialdini. Cialdini walks the reader through the many ways in which scarcity, among other things, can be used against us without our being fully or even partially aware of it.

When it comes to investing, scarcity is seen in manufactured situations like IPOs that only “preferred” clients and institutions can access. Other situations include ones that arise from random market dynamics. For example, when a market sector or security is enjoying abnormally strong returns, investors often don’t want to miss out on the opportunity, leading them to make their decision based on emotion, not reason.

Moreover, financial products like hedge funds are packaged with high minimum purchase amounts because they are only for “the rich”. This doesn’t necessarily mean they’re bad products, but you should understand that part of the reason they are sold this way is more a marketing strategy, than an investment one.

My favourite Groucho Marx quote is “I don’t want to belong to any club that would accept me as one of its members.” Unlike many people, Groucho understood that we have a natural inclination to want things we can’t have.

Suggestion: Whenever you feel the urgency to invest in something ask yourself, “Is there a legitimate reason to act quickly, or has that reason been manufactured or in my head?”

Some final thoughts

So you might be thinking, “Great, as if investing wasn’t complicated enough without having to worry about my own biases.”

Unfortunately, there’s some truth to that. Much like most things in life, investing is made harder when factoring in our emotions and biases. But don’t leave yet, there’s good news! You can improve on most, if not all, of these biases within a relatively short period of time. Just being aware of them and paying attention to your own patterns are huge steps in the right direction.

Be especially aware of those biases you’re most prone to and how they work in conjunction with each other, causing an exponential effect that Charlie Munger refers to as the Lollapalooza Effect. If you are a very confident person, you work in the technology field, and the technology sector of the market has outperformed other sectors for years, odds are you’ll be investing in technology stocks and putting a significant portion of your net worth in technology. This is exactly what happened to a lot of people in the technology bubble of the 90s that saw the ensuing crash wipe out many a life savings.

Years ago I had a client who put virtually all of his net worth into a junior mining stock, which had done very well. I practically begged him to diversify at least part of his portfolio into something safer. As the overall trend was positive, his confidence in the stock grew over time. Unfortunately, it got to the point where he ignored my suggestions to diversify. Shortly thereafter, we stopped working together. A few years later, I looked that stock up and discovered it had fallen to virtually nothing.

I often wonder if he ever sold at least part of his stock to salvage some money out of it, but deep down I know the answer. This series was written in part for investors like him who deserve better.