Investor biases and behavior are two of the important factors that determine success with long-term investing in the equity markets. Biases can be of many types such as home bias, recency bias, etc. Biases lead to behavior that can be damaging to an investor in terms of returns. For example, irrational behavior such as selling out when markets crash is usually not a wise move.

I came across an interesting article recently that discussed about some of the issues with investor behavior and how it affects their success with investments. From the article:

Heads or tails?

If a fair coin is tossed 10 times in a row and lands heads for each of the tosses, what would your choice be for the 11th toss? Many would guess heads, assuming that the current trend will continue. Others may choose tails believing that the trend must buck. But what has actually changed between the 1st and the 11th toss? Nothing – statistically there is still a 50% probability that it would land either heads or tails. So why favour one over the other?

When presented with information we interpret it according to our own biases, and then react to the information. Most of us are prone to drawing overly-strong inferences from previous, and especially recent, events or trends. The information during the first 10 tosses of the coin is irrelevant, as it has no bearing on the 11th toss – there is still a 50% probability of landing on heads or tails.

Now let’s consider a second example

You have an opaque bag containing 50 black and 50 white marbles and you have to remove marbles one at a time without replacing them. There would be a 50% probability of selecting a black marble on your first go. If you had just removed 10 black marbles in a row, what would your guess be for the 11th go?

Most of us should select ’white’ because there is a higher probability of selecting a white marble than a black one – the odds moved from a 50% probability on the first attempt to a 56% (50/90) probability of white on the 11th attempt. Unlike the coin toss example, the information presented between removing the 1st marble and 10th marble is extremely relevant in guiding our choice for the 11th attempt.

We are presented with a lot of information on a daily basis from which we have to make decisions. Fortunately our minds make things easier for us by using efficient thinking strategies known as ‘heuristics’ – mental shortcuts that help us make decisions and judgements quickly without having to spend a significant amount of time analysing the information. Mostly, heuristics allow us to respond rationally and effectively – like avoiding a pothole in the road. However, heuristics can also lead to errors in judgement, as we see from the coin toss example. Psychologists and behavioural scientists who have studied heuristics have categorised over 100 behavioural biases which lead to errors in judgement and irrational decision-making, including, over-extrapolation, anchoring (the tendency to rely too heavily on one piece of information), overconfidence, fear, greed and confirmation bias (the tendency to search for new information that supports one’s beliefs), to name a few.

These biases influence our success as investors

As we have discussed in previous articles, investor behaviour is a key determinant of investment success over time. Investor behaviour is driven by the psychological traps, triggers, and mistaken beliefs – because of over-weighting irrelevant information – that cause us to act irrationally and destroy wealth. (emphasis mine)

Source: How to be a better long-term investor by Shaeed Mohamed, Allan Gray

The entire piece is worth a read.