Many retail investors make the following mistakes. As professionals, it is our job to be cognizant of the following biases and to avoid falling into these decision making pitfalls.
Incomplete Memories:
This refers to the tendency for us to base our decisions on what we remember (which is not a complete picture). We weight our decisions towards our most recent events or our most accessible experiences. Our biological nature only allows us to remember the past in a limited capacity, as witnessed by our class not being able to recall our lunches the week before. There are also several instances that incomplete memories can also lead to sub-optimal decisions in the investing profession or even when investing individually.
Not realizing the cyclical nature of markets: For example, many of the investors who suffered huge losses in the financial crisis were quick to remember these losses, even if on aggregate their returns were still positive. This is most likely due to the gradual positive earnings compared to the sudden negative drop. These investors, due to the overwhelming negative emotions that they faced, were not willing to invest further, even though markets are cyclical and it is part of the market to have booms and busts. This is also tied to Myopic loss aversion.
Being too affected by sudden losses even if they are on aggregate less than gradual gains: Incomplete memories can mislead investors into making the wrong decisions if they put more weight into a more recent event that on aggregate should have a negligible effect on portfolio performance. For example if an investor a week ago bought a healthcare stock with a return of 25% and it dropped to 5%, and he or she refuses to buy healthcare stocks even though over the past year the average returns were 20% and above the relevant benchmark. This is also tied to Recency Bias.
Incorrect Memories: Another case in which investors can make sub-optimal decisions with incomplete memories is if they have incorrect memories. Sometimes, when we are primed to think that we did a decision or acted in a certain way even if we did not, over time we might accept other people’s inaccurate recollection of our actions as the truth. This may lead us into making wrong decisions in investing if people convince us that what we did previously – which was right – is wrong, we may make the same mistakes again. This can be tied to Herd Behavior.
Overall, incomplete memories affect our daily and investing decisions. Because our mind is primed in a way that haves us value what is most recent, most painful, and most common, as investors, we may be subject to making irrational and recurring mistakes.
- Gugnir
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