CONVENTIONAL THINKING SUGGESTS that the best decisions are the unbiased ones. But the fact is that we’re genetically rigged to make assumptions. We didn’t come out of the womb ready to operate as adults. Knowledge is learned, and our opinions on everything from sex to Cisco (CSCO) are simply the sum of our experiences. If you’re alive, conscious and have a brain you’ve got a bias.
And so it goes in trading. Some people are biased toward playing stocks from the long side. Others seem to be perennially short. Should I buy or sell Oracle (ORCL)? Or perhaps do nothing at all? Even nondecision is an active choice governed by your personal market biases.
What distinguishes the successful trader is that he understands his biases and knows how to overcome the ones that harm the bottom line. To help you do the same, here’s a look at the three biggest sources of trading bias.
The most common way biases are formed is through *previous experiences*. As a kid, it only took one serious burn for me to realize that touching fire wasn’t a very pleasant thing. More recently, we all learned that companies with a dot-com suffix have a strange tendency to deflate, decline or just disappear altogether.
But too often what we learn from a past experience and what we should learn are two very different things.
For example, after losing money when the technology stocks dropped in 2000 and 2001, many investors have developed a distinctly antitech bias. These days, technology companies, dot-coms or any company that isn’t posting a profit has been shipped to stock-market Siberia. For many people, anything tech is now off-limits in their portfolio.
It’s an illogical bias (just as the 1999 frenzy for anything tech was an illogical bias). These days, I talk to many investors who’ve sworn off everything from emerging markets to metals simply because they lost money before in that sector.
But as we often point out, trading success isn’t a function of what you trade but how you trade. The real lesson of the tech wreck wasn’t that you shouldn’t invest in speculative companies or companies without earnings, but that you should do so intelligently, and with proper trading technique.
Those who lost big money in tech got creamed not because they were in speculative stocks, but because they had big positions. And as hard as it is to hear, the same goes for the unfortunately loyal employees of Enron (ENRNQ) who had the majority of their 401(k) money loaded into company stock. The lesson of losses isn’t to trade particular securities, but to trade them in a smarter way. Indeed, when I lose serious money, it isn’t because I bet on any particular sector, but because I bet with bad form.
Another large part of people’s trading bias comes from *long-term price performance*. The most worthless investing insight is the idea that stocks are the best long-term investment on earth. It’s the mantra of millions of investment advisers and the thinking behind billions of dollars allocated to index or indexlike investments.
But the uncomfortable reality is that we have no certainty that the market will be higher over the longest of long terms. We have even less certainty that equities will outperform during our actual holding periods, which for most investors are decidedly shorter than the 72 years on which much of the long-term credo is based.
What’s ultimately the most predictive element of a stock isn’t its long-term past performance, but its more recent action. The fact that Kmart (KM) was a market leader 30 years ago didn’t stop it from crashing and burning, and if you held onto Enron because of its past glory, then you missed the technical signals predicting its more perilous present situation.
Yet I can’t tell you how many investors pass up good opportunities just because of their long-term past performance. While I respect the old maxim that those who forget history are doomed to repeat it, the truth is that those who dwell on the past often live there as well. The best trader’s bias isn’t toward the historically best stocks, but the currently best ones. As we’ve pointed out before, trading is like bar hopping: You’ve got to go where the action is.
Finally, many traders unfortunately have a bias toward *popular consensus*. There is nothing more brainless than following the herd, and for many traders following a pundit is much easier than taking the time and emotional responsibility for their own actions.
So they avoid stocks that a major brokerage has recently downgraded, or even those that have merely been the subject of criticism or doubt. It’s the Nuremberg school of investing: “It wasn’t my fault I lost money. I was just following orders.”
Because they harbor a bias toward the crowd favorites, they tend to focus on the most seemingly “safe” ideas by buying the most widely owned names. The truth is that an investor wants to seek out risk, not avoid it altogether. The game isn’t about avoiding risk, but learning to manage it better. So my bias is generally tilted toward those stocks or sectors that everyone avoids, because while it may feel more comfortable to follow the crowd, the biggest opportunities tend to reside in the least popular places. There’s a reason they call it “Heard on the Street.”
Because trading is ultimately about having an opinion, bias isn’t something we should avoid, but shape. It’s emotionally easy to avoid investments simply because of a previous bad experience or a bit of negative buzz. But the truth is that the past doesn’t always repeat itself and that the crowd is usually dead wrong. In the final analysis, the best bias is toward an open mind.
– Originally on Mar 04, 2002 by Jonathan Hoenig
