No matter how much work you do as an investor on researching opportunities, the biggest problem you’re likely to have is making sure you don't make silly trading mistakes.
This is why it’s important to know and understand the logic behind behavioral investing. One particular behavioral bias that we could all succumb to is action bias:
“One final aspect of the bias to action is especially noteworthy, the urge to act tends to intensify after a loss, a period of poor performance, in portfolio terms. Psychologists have asked people to consider something like the following scenario Steenland and Straathof are both coaches of soccer teams. Steenland is the coach of Blue Black, and Straathof is the coach of E.O.D. Both coaches lost their prior game with a score of 4-0. This Sunday, Steenland decides to do something: he fields three new players. Straathof decides not to change his team. This time both teams lose with the scoreline of 3-0. Who feels more regret, coach Steenland or coach Straathoff?Participants saw this statement in one of three forms. Some saw it as presented above -- framed in terms of a prior loss; others were simply given the second half of the above with no information on prior events, and the final group saw a version in which both coaches have won the previous week but lost this week.If the teams had one last week, then 90% of the respondents thought the coach making changes would feel more regret when the team lost this week. However, when the situation is presented as the teams losing both weeks, the coach not taking any action was thought to be feeling more regret by nearly 70% of the respondents. The logic was that "if only" the coach had made some changes, he might not have lost for a second week in a row. This highlights the role that counterfactual thinking plays in our judgments. When dealing with losses, the urge to reach for an action bias is exceptionally high.” -- James Montier, The Little Book of Behavioral Investing
Action bias is the desire to do something and it's extremely dangerous for investors. Nine times out of ten the best action for you to take as an investor is to do nothing. It's the strategy that's helped turn Warren Buffett (Trades, Portfolio) into a multi-billionaire over the years. However, most investors just cannot resist the urge to trade and it's one of the most destructive urges there is.
Trying to avoid it is not easy, then again if you know what it is, it's not hard. The first stage in avoiding action bias is just to be aware that it exists, when you know this you can take actions to make sure that you don't make the mistake.
Acknowledging that you will make mistakes, will help you put in place checks to ensure that you do not repeat them. Checklists are one way of helping. Checklists provide a speed bump that forces you to double check your actions, rethink the process and avoid acting on impulse. What's more, as humans we cannot be expected to remember every mistake and lesson we've learned. Incorporating them into a checklist as you go along will ensure that you don't forget these mistakes you've made in the past and ensure that you don't repeat them.
Another method to avoid making mistakes is to do your research. One of the points on my personal checklist is "Would I be happy if the stock fell 75%?" This is designed to force me to do my research and understand the business inside out. If I do this, then I would feel better about holding the stock if it fell 75% as I'd know more about the underlying business. Of course, this isn't a bulletproof failsafe, but it does minimize the risk of me taking action because I don't know what I've bought into. It's all about finding a process that you're comfortable with.
