Behavioral Finance Article In The Wall Street Journal Online

This article's already been picked up by Simoleon Sense, but I'm linking to it here because I want to highlight it as an easy-to-read introduction to cognitive and emotional biases that pop in when we invest or trade. It's called "The Mistakes We Make—and Why We Make Them," and it's by Meir Statman.

He spends more time on emotional biases than the usual intro. Regret is discussed thoroughly, but anchoring isn't mentioned. Prof. Statman has the gift of matching biases to investing activity we can all relate to; it's as if he had been there himself. He even ends with why a well-known investing technique gets around our regret bias. It makes for a good read.

An introduction to behavioral finance

The Globe and Mail has webbed an article that provides a basic introduction to behavioral finance, with four biases explained therein. It's entitled "Bad habits sow bad investments: Avoid traps created by overconfidence, herding, anchoring and regret." The four biases are explained in everyday terminology.

The authority quoted is Lisa Kramer. Her University of Toronto Web page is here.

Know Your Biases: Outcome Bias

When something's obvious in retrospect, it's hard to remember what things were like at the time. It's obvious that the market bottomed on March 9th, but that day was one of several plunges that took market-watchers by surprise. Back then, no-one knew what today's market would be trading at. What they did know was that the supposed November end to the bear market had turned into another vicious short-term growler - an unexpected one - as of February 9th. When Commerce Secretary Geithner made that announcement of his, the market participants were getting used to the idea that the worst was over and the new Administration had things well in hand. Because he had unveiled no specifics of any bank-rescue plan, that confidence vanished and the market dove in a hurry. It was to be that way, barring a few relief rallies, for the next month...a 28-day stretch when the S&P lost more than 22%. A full-fledged mini-bear market in the space of a month.

There was no way to tell whether or not the March rally was a sucker's rally. Given near-term experience as of then, there was no reason to doubt that March 10th, 11th and 12th was setting up another bear trap. We can look back and see that it was the start of a mini-bull market that ended on May 8th, pushing the S&P 500 up 28.5% in the meantime, but no-one saw it at the time.

For value investors, March 9th was like being tugged in two directions at once. Bargains were aplenty, but all signs pointed to those same bargains becoming more plentiful and cheaper. Dollars may have been selling for fifty cents, but it wasn't that long ago that they were selling for seventy cents. They may have been snagged at forty cents had March been akin to February. A larger cash position made sense given that dynamic. Cash didn't fall, and even bargains have to be marked down to market. Many value funds - most notably, Legg Mason's - were riding huge losses. A large cash cushion cushioned the mark-to-market bite, and also freed up the manager from having to sell more stocks later in order to snap up new bargains. Given a crushing February, holding a cash reserve made sense. JP Morgan may have gone down to $16, but who then would rule out it not going to $13 or even $10? It was more than $27 as of Feb. 6th.

According to Wikipedia, "outcome bias is an error made in evaluating the quality of a decision when the outcome of that decision is already known." It's easy in hindsight to see that March 9th was the day to buy with both hands, and it's just as easy to see that many bears should have reversed course in mid-March. The trouble with that hindsight, though, is that we are now habituated to a completely different market than March's. You didn't have to be a market timer to be affected, either. From a value investor's perspective, March 9th to May 10th was the season of the elusive bargain. Undervalued stocks were taking off at a pace that made a market order look like overpaying. Ballyhooed rallies exposed as sucker rallies were fresh in memory. Given this situation, who would risk looking like a fool by buying in to a rocketing market? Except for the foolhardy?

The above dynamic was what kept so many fund managers holding cash in the bag until it turned into holding the bag. It's easy to conclude that they were just stubborn, or bureaucratic, but they didn't know then what we know now. More to the point, we don't know now what they knew then. (We don't even know how many limit orders expired unfilled in those two months.) The above only sketches it out.

Outcome bias is hard to avoid because we naturally factor in present information when evaluating a past decision. We can only adjust for it by using our memories as best we can, and reminding ourselves that what goes around comes around. Perhaps, the most that can be realistically hoped for is to not inflame the bias.

When you think about it, there are a lot of trading systems and E-Z Investment books whose sole source of credibility is their appeal to outcome bias...

Know Your Biases: Irrational Escalation

Have you ever tried to play poker using a system? If so, then you know that a large component of any poker system tells you when to fold - especially, right after the ante. Another component of a good system confines heavy betting to a hand only above a specified value.

One of the frustrations in using a system like that is the restraints imposed when someone else bets big with little evidence of a high hand to back it up. It does hurt to throw away a hand only to learn that an opponent was bluffing with a lower-valued hand. Often, it irritates; in so doing, it creates a fertile emotional field for irrational escalation.

According to Wikipedia, "Irrational escalation" refers "to a situation in which people can make irrational decisions based upon rational decisions in the past or to justify actions already taken." It's closely related to the sunk-cost fallacy, in which the amount of money already thrown in determines or heavily influences the decision to throw more money in now.

Simply put, this bias surfaces when an unexpected and frustrating result makes us mad enough to push harder and escalate our commitment. It's the bane and plague of value investing.

After all, a lot of value investing consists of throwing good money into good stocks with bad price trends. If I thrown a haunch of money at a stock at $10 or so, see it go down to $8, throw more money in, see it go well below $8, throw a little more in, etc., am I beholden to sunk-cost bias? Am I averaging down into a increasingly cheap value play? Am I under the sway of irrational escalation?

The fascinating aspect of value investing is that all three of those questions can be answered with "yes" if asset allocation theory is factored in. I believe that many of the great value investors sometimes use their all-too-human tendency for escalation of commitment to buy cheap stocks even more cheaply. The difference between they and the more hapless kind of investor is a careful lookout for red flags, which help minimize irrational escalation. These red flags are picked up through experience, particularly bad experiences. The trade knows them as "value traps." Put as simply as can be, a value trap is a company that has a knack for inflaming a value investor's irrational-escalation bias.

For example, a low P/E stock shows up in the Low P/E Bin. Its stock price in a downtrend, and a study of the company's financials indicates that it's a cyclical company. The last recession, the company's earnings bottomed out with losses. Losses haven't shown up so far, despite the progress of the recession, but the last time the same company showed losses was in 2002. If it showed losses at the end of the last recession, its time for losses may very well be the end of this one. On the other hand, it may have beat the cycle this time.

It's clear from a study of the long-term financials that this stock runs a real risk of showing losses this year. If I go in, I might be bailed out by a rising market even if the company does go lossy...but that's a hope, not a solid basis for investing. It may also have a low P/E as based on its ten-year earnings, but it still has the potentiality of being a short-term value trap. Such companies, I suggest, are best not doubled down on if invested in. At the very least, they tie up capital for an extended period of time while throwing the entire portfolio out of balance. Moreover, we only know the end of the trough in hindsight. It can get worse than we imagine.

Some of the red flags are subtle, as well as debatable. When I highlighted Harvest Energy Trust as a value stock, I was going against a red flag that many experienced investors use: "Don't bother to invest in a currently-profitable company that's likely to show a loss in the near future, no matter how cheap it is with respect to book value. Such companies can become a lot cheaper in a hurry. It's best to wait until the dust settles."

Harvest has turned around largely because natural gas and the crack spreads have reversed course, as of now. In retrospect, I was counting upon economic recovery and inflation seeping in. If I end up being wrong, I will have stuck a fair bit of imaginary dollars in my actively-managed Marketocracy mock fund into a large and sustained value trap. Had I been value investing for real, it would have been real dollars in that trap.

To return to the poker analogy, a value trap is a lot like a known bluffer that bets meekly, then aggressively, then meekly again, then aggressively with his or her usual air. Then, when the fur stops flying, (s)he lays down a full house.

Once burned, twice knowing.

Management Compensation And Anchoring

One of the perennial issues regarding management is compensation levels, and the usual assumption is that they're way too high. Value investors tend to echo those complaints, seeing high compensation levels as evidence of management chicanery and/or fecklessness. There's also some talk about the good old days, when top management was happy to grow a public company at five figures annually.

I realize I'm breaking somewhat with the consensus on this issue, but I wonder how much of the presumption that management is generally overpaid is the result of anchoring bias.

Let me bring in a example in the same timeframe, but from a different career. Back in the day when a CEO was happy to work for $50,000 a year, plus perks like the unwritten right to be the only employee to drive a fully-loaded Cadillac and status goods such as an imposing office plus a taboo-surrounded exclusive address, it was tough financially to be in professional sports. A player had to be in the top league to have a serious chance at making middle-class-level money from his skill. It wasn't uncommon for players to work other jobs off-season. The biggest ice hockey star of the 1950s, Maurice "Rocket" Richard, had a base salary of $15,000 a year in the early-mid 1950s; it was later dropped to $12,000 a year. The most he ever made in a year (including bonuses) was $25,000.

In other words, the biggest ice hockey star prior to Gordie Howe made, at best, about as much as a senior vice-president of a large company. A more normal compensation level for him was middle-management range.

Professional sports stars are heroes to many, and we like to believe that they were woefully underpaid back in the olden days. Not so for management: much of the charge of overpaying is anchored in 1950s salary levels.

It's a pity that the 1950s aren't studied more closely by those management critics who invoke the salary levels of those times. Critics of management culture back then pointed out that the "Organization Man" had to always be on his toes, had to carefully conform to the corporate image, even had to marry in a company-compatible way, had his [yes: back then it was "his"] choice of home circumscribed by an unwritten pecking order, and had to be careful to show due deference to the boss and to top management. The boss that wanted to be everybody's friend was quickly sized up as a potential tyrant, if rubbed the wrong way. One of the rules of organization survival was, "if you play the boss [especially the top boss] at golf, better make sure he wins." It was a time when a union man could cause a scandal, and become a folk hero, simply by buying a Cadillac and driving it to work.

Anyone studying the writings of corporate critics in the Organization-Man era would have to conclude that, along with the relatively modest paycheck which a CEO drew, the top boss had a large psychic payment in terms of status. The two definitely hung together, and the explosion in CEO pay could be seen as monetizing that status.

Unfortunately, many of today's critics of management lack a sense of history. Many of them also live on our anchoring bias. It's hard to swallow the conclusion that 1950s [and 1960s] management were woefully underpaid in terms of money, a conclusion that also follows from the top-management salary explosion of the last thirty years, but the point about status suggests a trade-off was in place too. Perhaps the "outrageous" salaries of today's management represent the better of the bargain, especially since the prestige of top management has eroded to the point where activist investors have a fighting chance against management over any issue. In the 1950s, none of them did; none of them. Not even Benjamin Graham himself.

Know Your Biases: Choice-Supportive Bias

As part of its service, Marketocracy provides its mock-fund managers with archived Web pages showing the funds' composition as of a certain day. Perhaps unfortunately, we don't have that same capacity in our own heads. We can't shift our memories to a specific point in time and recall our mental state at that time. We can't fully recall what options we weighed at the time of an earlier decision, let alone our intuitive and emotional states as of then. We even find it difficult to untangle "should" and "could" when re-assessing a previous decision. The question, "I should have done X in retrospect, but could I have at the time?" is a very difficult one to answer.

Instead of reliable archives, nature has given us egos. There's a certain blessedness in that, as we can really cut ourselves down by should-ing ourselves over decisions made without the benefit of later hindsight. Unfortunately, our ego strength also opens us up to a certain bias.

According to Wikipedia, "choice-supportive bias is a tendency to retroactively ascribe positive attributes to an option one has selected [because one has selected it]." As we commit to a decision, we begin to mix in hindsight in a self-justifying way. "I bought stock ABC because I thought it was undervalued" becomes "I legged in to ABC because I thought it was undervalued but wasn't sure it'd be even more of a bargain" to "I'm dollar-cost averaging. ABC is a long-term winner." It's not hard to see how choice-supportive bias amplifies illusion-of-control bias.

On the Street, the most known kind of choice-supportive bias is encapsulated in an old maxim: "A 'long-term investment' is a speculation that didn't work out." As the above example indicates, room could be made for "'Legging-in' means busting your allocation model."

There's no easy way to get around choice-supportive bias, as it does tend to go with a healthy ego. Detail-oriented people have the option of keeping a detail-rich trading diary, and letting it serve as a memory-substitute. Unfortunately, this countering places a premium on making decisions verbosely. Many decisions are based on intuition; as intuition is honed, unverbalized reasons accompany verbalized ones. Few people - and far fewer action-oriented people - have the introspective skill to tease out explicit reasons from their intuitions.

The best way to minimize it is combining a trading diary with cultivating the skill of self-honesty. It's a tricky skill beause we're often prone to confuse self-honesty with being hard on ourselves. Castigating yourself for not seeing a March earnings disappointment in February does tend to cross that line. Some people take up technical analysis in consequence.

On the other hand: if a competent and reasonable stock picker would have foreseen a defect at the time, then there is grounds for self-criticism. Choice-supportive bias does tend to erase legitimate self-improvement opportunities. As noted above, though, minimizing choice-supportive bias also requires minimizing both varieties of hindsight bias: the self-justifying kind, and the self-castigating kind.

Know Your Biases: Bandwagon Effect

It takes only a bit of time in the stock market before the frequent disconnect between fundamentals and stock price movements become apparent. There's always a temptation to try to outguess which stocks are going to move and which aren't, using as the basis the companies' financials and combining them with news releases. Those who know about the efficient-market hypothesis should recognize it, in back-woods form, in that desire.

I can say from experience, though, that anyone who tries it is bound to get swamped by cognitive dissonance. Often, the number of contradictory ideas become several or many. As a result of the consequent confusion, a value investor often returns to the fundamentals and gives up on the idea. The most that can be gained from such an exercise, even when confining oneself to real value stocks, is skill in trading. Any market sense acquired from this attempt is a trader's sense.

Doing so does lead to confrontation head-on with the bandwagon effect. Regardless of the long-term futility of "trading value," another useful byproduct of such an exercise is confronting, and ideally besting, that cognitive bias. I offer the opinion that it's best done with a mock account.

According to Wikipedia, the "Bandwagon effect...is the observation that people often do and believe things because many other people do and believe the same things." It surfaces all the time in the market place, including in areas far removed from speculative frenzy.

Why is stock ABC going up while stock XYZ languishes? The question is puzzling when ABC and XYZ are about the same value, but poignant when XYZ is the better value. It's normal to search for a news item or other piece of information explaining why, but in many cases there's none. The bandwagon effect seems to start out of nowhere, run its mysterious course, and then stop. It's always explainable, if only through the word "anticipating," but it's never predictable.

The kind of bandwagon effect I just pointed to is a relatively benign one. It's caused by a value stock moving from out-of-favor to more favorable status. Value investors, except for those solely in it for the dividends, actually count on the bandwagon effect acting on an undervalued value stock^* to bring it up to fair value.

There's a more baleful version of the bandwagon effect, which acts more like a plague on value investors. It visits when the selling bandwagon gets rolling, to the detriment of a stock that good analysis has shown to be good value. I can say that a value investor has not earned his or her spurs until s/he has sweated over an undervalued stock that's become even more undervalued in a hurry. In a lot of cases, the stock has gone on sale...but we're all susceptible to the bandwagon effect when we're anxious. Averaging down does take some guts in many situations; reviewing the fundamentals to see if the value's changed does take a dollop of forbearance...even if it's easier to descend into contrarian cynicism and say, "to hell with it. The stock's being driven down by the mob; nothing more." Reacting in this way does avoid conformism, but it's still reacting.

There are always those value traps...


*: That phrase isn't redundant. Other kinds of stocks can be undervalued too, particularly ones that show stronger fundamentals than were previously evident. The most speculative example I can think of would be a mining-exploration penny stock that scores great drilling results on a previously unremarkable property. I don't think anyone can call an exploration penny stock, however undervalued in retrospect, a "value stock." The same demur applies to biotech research firms who discover a profitable compound, or who get favorable FCC results, or otherwise show that their prospects were generally underrated.

Know Your Biases: Framing

According to Wikipedia, a "frame in social theory consists of a schema of interpretation—that is, a collection of stereotypes—that individuals rely on to understand and respond to events." In other words, framing is a kind of cognitive tunnel vision in which a schema of interpretation makes relevant data appear irrelevant.

Like many other cognitive biases, this one seems all-but-universal. The Wikipedia entry on framing tends to take a point-counterpoint approach that contrasts frames, instead of illustrating how to think beyond them. It could be that framing is simply the incorrect use of focusing, which we need to do to think at all.

There's no question that we like narratives, and tend not to like them interrupted with a counterexample unless explained as not impugning them. Look at these two examples to see what you prefer:

Example 1: Dividends should be reinvested because they boost the portfolio return significantly. A look at the growth of two portfolios, which only differ on full reinvestment or lack of, shows it. Although this approach means refraining from drawing income from the portfolio, the benefit of reinvestment sheds light on the true opportunity cost of doing so.

Example 2: Dividends should be reinvested because they boost the portfolio return significantly. A look at the difference in growth between a portfolio that reinvests all dividends and one that reinvests none illustrates this point. The point, however, is irrelevant to someone who would rather take out the dividend income from his/her portfolio after taking into account the opportunity cost of doing so.

The first example uses a frame. The second does so too, but calls attention to it through adding a counterexample. Which one's easier to assimilate?

Example 2 might remind you of an academic paper. Academics tend to de-frame their papers by limiting the scope and/or pointing out relevant exceptions. The most famous example of de-framing was Albert Einstein's triple test of his own General Theory of Relativity. He was careful enough to say that it would be invalidated if any one of those three predictions didn't pan out.

In the less recondite area of investment, spotting frames is as easy as getting your hands on a research report. Perhaps inevitably, for the sake of reader interest, the financial press is full of framing. Wise consumers of financial news just take it in stride. Some bloggers poke fun at the process.

In the more serious area of investment decisions, though, framing does cost. Typically, framing nurtures an already-existing cognitive bias. Frames go well with, say, overoptimism bias or confirmation bias. When it comes down to brass tacks, the only way to avoid framing is to tease out assumptions from an investment strategy. I've found that doing so is an acquired skill, and is often hard to learn.

Example 1 above assumes that every rational dividend-collecting investor wants to boost his/her return without thought of any extra-portfolio monetary needs. This entire blog assumes that non-ETF stocks with market caps of 500M or more, P/Es in the lowest quintile as screened by Google Stock Screener, and yields greater than the inferred yield of S&P SPDRs, constitute a set of stocks that's worthwhile to track. Consequently, it's a value-investing niche blog. Some people, although convinced of the statistical superiority of low P/E stock returns, think that the dividend requirement is irrelevant. Others think that the low P/E effect is but a chimera, or an anomaly that won't last. Investors in cyclical stocks know that cyclical stocks tend to exhibit low P/Es near their tops rather than near their bottoms. A deep-turnaround specialist knows that some turnaround stocks show a low P/E long before they're buyable.

As I hope I've shown, I'm aware of (some of) the limitations of this blog's underlying investment philosophy. Had I been more subject to framing, though, I would have brushed aside those exceptions...or the fact that the low P/E anomoly is statistical in nature.

In the everyday world, framing is known as "assuming." There's a '70s-era witticism that says, "if you assume, you make an ass out of u and me." It's not very academic, but it gets the point across.

Anchoring And The Earnings Two-Step

These last three trading days have shown how prevalent anchoring is. At the individual company level, managements of closely-watched popular stocks have become pretty good at massaging our anchoring biases. Just shoot out pessimistic guidance, and you've got the investment community anchored good. A temporary decline in the stock price can be chalked up to previous overoptimism. Then, once the guidance is settled into the players' minds, out comes the earnings report that beats the consensus. Punters fall for it so regularly, some traders try to make a living playing the Earnings Two-Step.

More broadly, there's a definite company-driven anchoring effect with respect to the entire market. Unlike a specific fact or figure, the relevant anchor is more abstract. If a well-watched company shoots up because it beat its numbers, or it's confounded famous analysts to the upside, then good news will be in the offing for the market in general. The anchor in question, whose specifics change from day to day, is the price of any such stock just before the good news is released. If said news triggers an upsurge, then this augur augurs well for the overall market.

Interestingly, this effect is more regularly evident on the upside than the downside...although sometimes the general market can be wrecked by a "slight disappointment" from a hot company. There are also traders who play the averages using this anchoring effect as a kind of schtick.

Aside from interest taken in the human comedy, the effect of anchoring in the stock market only has an indirect impact on value investing. This bias sometimes makes stocks go on sale, and sometimes gets Mr. Market manic enough to offer a good price. The more relevant point is that it's possible for an abstract principle to serve as an anchor. In my relatively fatalistic entry on anchoring, I observed that many value investors are anchored on the idea of buying a dollar for fifty cents. Like all abstract anchoring, this principle serves as a benchmark used to measure something up - in this case, a potential value stock. Perhaps I took this approach because I'm reconciled to being easily anchored myself, but I believe that the effect can be useful if used properly. At a much more active (and risky) level, the above-mentioned traders try to do so too.

Some others, like Ben at the Inoculated Investor, concentrate on shaking off anchoring bias. His well-written cautionary discussion can be found here.

Know Your Biases: Extraordinarity Bias

According to Wikipedia, "Extraordinarity bias is one of the cognitive biases. It is the individual and social tendency to value an object more than others in the same category as a result of an extraordinarity of that object that does not change the value in itself."

The application of this bias to value investing may well be most exhibited in basic chart reading. An extraordinary leap in a stock doesn't change its fundamentals, although such a leap could be signalling a change in them. On the other hand, there may be no change. Similarly, a leap of that sort could be evidence of a catalyst turning an undervalued stock into a fairly-valued issue - but it might not be.

In the short time I've been running my actively-managed mock fund at Marketocracy, I've seen two leap-ups of that sort turn sour. Both of these stocks were in the Low P/E Bin when they started taking off. The first was Teekay, which I put in the mock fund. The second was WSP Holdings, which I didn't. Teekay hasd a run-up in early June which carried it to almost $23.50. Impressed, I had bought in at about $23. It's now below $19.

The other, I didn't react to. WSP Holdings also had a huge run-up in early June, to more than $7. It too fizzled, and the stock sunk back to $5.18 before rallying somewhat over the last week. There's a current example of a stock roaring up simply on the basis of an upgrade: Deluxe Corp. Given the above two outcomes, it may be the best course to wait for a sustained pullback if Deluxe is deemed a buy on other grounds.

Extraordinarity bias, in a chartists' context, also applies to sudden drops. The extraordinariness of a drop, although suggestive of future trouble, does not necessarily mean that the value of the stock has changed for the worse. It may just have gone on sale. The most famous example in value investing lore is American Express' plummet in 1962 after the salad-oil swindle was unearthed. Warren Buffett took advantage of this plunge, after making sure that its fundamentals were not in fact deteriorating, and scored a quick profit. The extraordinality of the exposed fraud made Amex look awful, even though an analysis showed immateriality.

A more recent (if more modest) example of a short-term plunge was Barclays plc dropping more than 10% in the beginning of June, because the Abu Dhabi sovereign wealth fund sold its stake in the bank. Barclays has since recovered to almost the same price the stock was at before the offloading was announced.

In the first case, taking account of extraordinarity bias means avoiding the temptation of buying a stock that's leaping up, unless there's solid corroboratory evidence that its fundamental value has improved. In the latter case, in the absence of any sign of definite weakness, buying the stock would be a proper course if it's a good value on other grounds.

This example of extraordinarity bias is only one of many in the stock market. Many stockbrokers rely on this bias to make sales.

Know Your Biases: Confirmation Bias

According to Wikipedia, "confirmation bias is a tendency to search for or interpret new information in a way that confirms one's preconceptions and to irrationally avoid information and interpretations which contradict prior beliefs." As with illusion-of-control bias, confirmation bias is not exactly unknown in the stock market.

Perhaps the reason for its prevalence is that much of the data we need is inconsistent. A person who diligently puts down a pro- and con- list, and assiduously searches for disconfirming information for his or her initial conclusions, might wind up doing nothing at all. There's no global weighting card that enables us to assign proper weights to this positive datum and that negative datum.

Instead, we have to use filters, diversification and a dollop of fatalism. Even the best filters don't screen out all lemons, and filtering is subject to an optimality criterion. Screening out potential lemons also means screening out some potential oranges. Since none of us know the future, we have to pick a screening system, an optimality point, and basically stick with both. And let the outliers go without beating ourselves over the head about missing them.

It's easy to see how this fatalism can transform into confirmation bias. When we're anxious and uncertain, a slice of reassurance can do us a lot of good. We all need reassurance from time to time, but reassurance junkies are also hooked on confirmation bias.

Perhaps it's like anchoring, in the sense that we investors can never completely shake free of it. If this be the case, then self-knowledge is the best way to cope. Sometimes, it hurts to say that such-and-such is outside of one's circle of competence...but saying so does indicate a certain emotional maturity.

Know Your Biases: Illusion Of Control

According to Wikipedia, "Illusion of control is the tendency for human beings to believe they can control, or at least influence, outcomes that they demonstrably have no influence over." As I'm sure you know already, this bias and the stock market are not that separate from each other.

Outside of Benjamin Graham's "Mr. Market," allegories for the stock market tend to emphasize our weakness with respect to it. "The market god" is an old favourite, although some prefer to conjoin "goddess" with a bad word in front.

These symbolizations are designed to make us shed our illusion-of-control biases when investing or speculating. Some people get scared, and some get scarred through not listening. Speculators, particularly momentum traders and pure chart junkies, are the group most reputed to suffer from this bias.

Unfortunately, there's an insidious variant that gets into the skull of a naive value investor - the kind that you'd believe is inoculated against this bias. The value-variant of the illusion-of-control bias can kick in when a value guy's found a real bargain...a real dollar selling at only fifty cents. The kind that makes a real value investor exclaim, "If this goes down, I'll be sure to buy more of it!"

That question - "if the stock you like goes down, would you buy more of it?" - marks the turf where the illusion of control bias lurks. What if you snap up the dollar at fifty cents, only to find it selling a week later at forty-five cents? Would you buy more?

If so, would you buy in further if that dollar sinks down to forty cents? Provided that the fundamentals are as sound as they were, would you "double-dog down" on the stock?

What, then, if it falls to thirty? Then what?

In many cases when this bias runs rampant in the excited value investor's brain, the dollar is genuine - and the averaging down does pan out eventually. The trouble is, as the averaging down continues, portfolio balance gets out of whack. So, if the dollar winds up falling to twenty-five cents, and it takes its sweet time getting up to a dollar, the excited investor has to sit on the benches waiting for it to turn out...while having months of losses to sweat over while being haunted by imaginary flaws.

In addition: tying up the portfolio in that way means that other opportunities have to be let go, even if they're more compelling than the first - unless said investor bites the bullet and takes a large loss. Since patience to fruition is a silver rule in value investing, this step is a very difficult one for value investors to implement. If part of the position has to be liquidated because of immediate money needs...

It would be nice to believe that the illusion-of-control bias can be rendered harmless by sound analysis and valuation self-discipline. It can, but only under three conditions: one, you're absolutely sure you can hold on to your position forever; two, you don't care about an interim loss even if it persists for some time; three, no-one else involved cares either. If all of these conditions don't obtain, then self-discipline in portfolio management has to be the immunizing agent.

That third condition can obtain for an individual investor, but often doesn't for an institutional investor. These people not only face market pressures, in the form of liquidations if they stick to their guns, but also legal pressures. Given the current legal climate, it isn't very far-fetched to imagine that a Ben Graham value manager might be sued for holding on to too many "value traps" ...only to see them spurt up after an adverse judgment's been handed down. It's that kind of a world sometimes.

Know Your Biases: Anchoring

From Wikipedia's article: 'Anchoring or focalism is a cognitive bias that describes the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions.'

This one's dogged me all my life. Back when I was five, a school psychologist noted that I was "ready to give up after a few seconds of trying unsuccessfully." When I learned to persist, I found that I was slow to shift gears if I didn't size things up right at first glance. I still have that trouble now, especially in tasks that require practical thinking.

The likesake of me is effectively obliged to cope with that innate tendency. The best way, I aver, is to latch on to a principle that's tried and true and make it the anchor. "Buying a dollar for fifty cents" is one such principle. It's hard work finding out if the supposed dollar really is one, but the principle itself need not be altered. I suspect that the greatest value investors use anchoring in a positive way, and the way to become a better investor is to do so yourself.

To put it succinctly: if you exclaim "Where has this been all my life?", that's your anchor. Let your anchoring bias work for you. I tried to fight it earlier in life, as the above assessment rankled, but my pride in the matter may very well have cost me some.