15 Mistakes to Avoid to Make a Killing in the Markets1 |
15 Mistakes to Avoid to Make a Killing in the
Investing is as much about trying to keep one's head when everyone around is losing
theirs, as it is about getting first rate information and performing cutting edge analysis.
It is as much about being fearful when others are greedy and greedy when others are
fearful, as it is about accessing quarterly results and applying complex research model.
And it is as much about buying only when the stock is available at a margin of safety as
it is about putting a company's historical statements on an excel sheet and performing
What I’m trying to say here, is that when it comes to stock market success an individual’s
behaviour is as important, if not more, than research and analysis.
If you are reading this guide, you must be wondering whether you also make behavioural
And in fact there are some common mistakes most investors tend to make throughout the
investing process - ie, when picking, buying, holding and selling stocks.
As you take stock of the successes, pitfalls, and mistakes you make in your investing
history, you will probably find – like most everyone else – that those mistakes were made
because of your own behaviours.
Most mistakes investors make are due to their own biases which keep them from making
rational decisions. These biases are psychological - they are basically 'hard wired' into us
as humans, and in many cases are very helpful in making decisions. In investing however,
they often lead us to poor decisions and loss of returns.
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If you take the time today to become aware of the mistakes you might have made in the
past, correct the biases you may carry, and go forwards with greater understanding and
better investing decisions, I believe you will find much greater investing wealth in your
Below are some of these biases, how they work, and most importantly, how you can avoid
1. Anchoring Bias: Most people are
over reliant on the first piece of
information they come across. For
example, paying Rs 1,000 for jeans
with a 50% discount on a rack rate of
Rs 2,000 may look like a steal, even
when it might be available for still
20% lower at a store next door. Most
often, in stock investing, anchoring
bias is based on past stock price.
For instance, you may not want to
buy a stock at Rs 100 if you know it
has traded at Rs 80 last week... Even if the real value of the stock is Rs 200...and
the stock may never correct back to Rs 80.
To overcome this bias - forget about past price, and always think only about the
current valuation of the stock.
2. Choice-Supportive Bias: When you choose something, you have a natural affinity
towards it and tend to feel positive about it, even when it has its flaws. For example,
you still believe your own dog is the best - even if it bites people every once in a
while. This leads to 'marrying a stock', that is holding on to your choice despite all
the fundamental negatives, and ignoring newer information.
To overcome this bias, think about your stocks as though you are investing in them
for the first time - with 'fresh eyes'. Ask yourself, would you choose to buy the same
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3. Ostrich Effect: The ostrich effect
takes the choice bias further. It is
to ignore dangerous or negative
information by 'burying' one's head
in the sand, like an ostrich. While
you don't have to keep checking
on how your stocks are doing every
single day, choosing to ignore vital
information about the business can
So, make sure to stay updated on the big moves the businesses you have invested
in are making, what it means for them, and then make a decision whether you will
act or not.
4. Bandwagon Effect: The bandwagon
effect is essentially groupthink,
i.e. blindly following what others
are doing because it seems to be
working for them. The probability
of one person adopting a belief
increases based on the number
of people who hold that belief. Is
your conviction about a particular
stock higher when your broker, your
neighbour, your best friend, and
everyone you know, is buying it?
That's the bandwagon effect in play.
Sure, you don't have to be a contrarian about every single decision you take, but
following the herd without doing your own research, will lead you to holding falling
knife rather than anything else.
5. Complexity Bias: Simply put, it is the belief that complex solutions are better than
simple ones, or to say complex businesses are better than simpler ones. While
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complex businesses have a lot going for them, it does not necessarily make them
better than simpler ones. In fact, great investors really focus on 'simple' businesses
which they understand.
Warren Buffet calls it his 'circle of competence' and has been quite disciplined in
staying within it. Your 'circle of competence' would comprise all the businesses that
you are familiar with and thoroughly understand.
6. Confirmation Bias: We tend to pay attention only to information that confirms our
preconceived notions. Once we have a notion in our head, we tend to selectively
look for evidence supporting the notion. As they say, first impressions are the
most lasting. Confirmation bias causes no harm if the initial notion or impression is
correct. However, if it is wrong, the bias prevents us from realising our error quickly.
One way to avoid being suckered into confirmation bias is to constantly question
yourself, and play devil's advocate to try and look for conflicting evidence.
7. Recency Bias: This is the tendency to weigh-in the latest information more heavily
than older data. If you look at a stock, which has been going down for a few days,
you tend to believe that the particular stock is not a good one. However, only when
you look at the long-term trend, you realise that this is but a mere blip in the stock's
life. The opposite holds true as well. You see a stock outperforming, only to realise
the rally was short-lived and unsustainable.
Recency bias can make you miss out on good stocks, or lead to losses by jumping
on to unsustainable ideas.
8. Survivorship Bias: This is the tendency to only look at data that has 'survived' or
excelled, while ignoring anything that didn't make it. Survivorship bias can lead to
overly optimistic beliefs because the failures are ignored. For example, if taking a
particular course of action worked for a business, we tend to believe that it was the
right thing to do, without considering the fact that many other businesses did the
exact same thing - but failed.
To avoid this bias, best not to just dwell on past results and performance and look
at businesses more objectively.
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9. Information Bias: This is when one
tends to seek all kinds of information
that doesn't really affect action.
That is to say, even with enough
information, one wastes time trying
to collect more information, even if
that has no use in the situation. More
information is not always better.
The key to successful investing is to
separate the wheat from the chaff and filter out unnecessary information, which at
best will waste your time, and at worst will distort your judgement.
10. Outcome Bias: Judging your decision based on the outcome, rather than how the
decision was made, reeks of outcome bias. Sure, you made a good return on a
stock tip from your broker. But does this mean, tips are a viable method for good
returns? What happens when they don't work?
Focus on how you came to a decision to buy/sell a stock, rather than the outcome
of it. It will not only help you avoid the same mistake, but also help fine tune your
11. Clustering Illusions: This is when you start seeing patterns in random events. The
belief that the market will go up after four straight days in red, is a classic example.
View your investing philosophy as separate from events in the market. The stock
market has a mind of its own, and its movements are more or less random. Trying
to predict market movements will only end in pain.
12. Availability Bias: This happens when you overvalue the information that you
possess. It may well be the case that the information you are using to base your
judgement of is incorrect, or incomplete. Availability bias makes you think that the
examples that come to your mind are more representative than is actually the case.
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For example, if you just got a new job you are more likely to believe the economy
is flourishing and the job market is great. However, someone who just got laid off
might not share your views about the same economy and job market.
A way to avoid availability bias is alter your focus on the long term and be sure to
weigh in other perspectives before jumping to a decision.
13. Incentive Bias: One of the most
important consequences of
incentives is what Charlie Munger
calls 'incentive-caused bias'. The
following example will best explain
Early in the history of Xerox,
Joseph Wilson, who was then in
the government, had to go back
to Xerox because he couldn't
understand why its new machine
was selling so poorly in relation to its
older and inferior machine. When he
got back to Xerox, he found out that
the commission arrangement with the salesmen happened to give a large incentive
to push the inferior machine on customers. An incentive-caused bias can tempt
people into immoral behaviour, like the salesmen at Xerox who harmed customers
in order to maximize their sales commissions.
The story of mutual funds in India is similar to that of Xerox. Mutual funds that offer
the maximum commission to distributors are the best sold funds. Also, consider
your own stockbrokers. There will seldom be one who will not lure you to trade too
Understand the motives and incentives of people and organisations you're dealing
and investing with. Everyone ranging from the company you're investing in to
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your stockbroker, your mutual fund agent and your equity advisor, your source of
information (yes, even I) must pass your scrutiny.
14. Conservatism Bias: This is when one tends to hold on to old investing views or
forecasts at the expense of acknowledging newer information. For example, if an
investor believes a certain forecast of a company's sales to be true, but soon after
he receives newer information that one of the company's plant had to be shut
down, he may under-react to the news because of his original impression rather
than acting on updated information.
To steer clear of conservatism bias, be open to new information and change or
amend your actions accordingly.
15. Blind Spot Bias: If you made it
through the list without identifying
with any of the biases, this one is for
you. Failing to recognize your own
biases is a bias in itself. This puts you
in a blind spot, where it becomes
difficult to understand reasons for
failure without some introspection
first. People tend to notice cognitive
biases in others, more than they do
To take control of your investing process, take a step back and understand the
biases that are holding you back.
Understanding you own biases and taking control of them can help you become a
And when it actually comes to picking stocks, you always have my recommendations
for that - check out my list of 4 small cap stocks that are set to profit from the market
crash in the rebound.