Deluded Investors Even the wisest and most rational of investors can be led astray by the evolutionary wiring of every human mind. The following are four of the most pervasive psychological biases that often trick investors into making bad decisions. Confirmation bias arises whenever we have a strongly held opinion about something, particularly when we have made a big effort to gather and analyze a lot of information before arriving at our opinion (exactly like when assessing an investment opportunity or forming an opinion about whether a market space is “hot” or not). There are two dangerous effects: The first is that investors become very attuned and receptive to information that appears to support their initial opinions. For instance, they tend to notice every newspaper article that can be interpreted as support for their belief. The second is that investors can become quite blind to information that appears to refute their opinion. TIP: To avoid confirmation bias, spend your time trying to find information that refutes your beliefs, instead of more information that supports them. Over-confidence is having a belief in one’s abilities that is greater than the objective facts warrant. In psychometric tests, investors repeatedly show some amazingly high levels of over- confidence. This is a real cause for worry. Most investors are justifiably confident since they are highly skilled and able. But, while their abilities might well be somewhat better than the average person’s, they tend to think and act as if their abilities were much, much better. Investors will therefore be over-confident in their abilities to pick winners and to add value to their investees. There’s a deep lesson in the observation that most VC funds have a hit ratio of only one in ten investees becoming successful. But most VC investors seem unable to learn from it because they are caught in their own over-confidence. TIP: To avoid over-confidence bias, make your decisions based on objective data about what you actually have achieved in the past, not what you subjectively think you should be able to do in future. Availability bias is the mistaken belief that situations that you have experienced must be very common out in the world. But it is false logic. It can be extremely dangerous to generalize too widely from our own experience. Our own experience is not typical and is not to be blindly trusted. Availability bias often sounds something like, “I heard that BigFundCo got a 10X exit in the cloud computing space, so I’m going to invest in the next cloud deal that crosses my desk.” TIP: To avoid availability bias, keep reminding yourself that your experience is unique and that there is no reason to think that it corresponds to what real market data would say about the average person. Prospect theory explains three interrelated biases. First, people give too much emotional weight to small chances, thinking that a 1% chance is much better than no chance at all, and that a 99% chance is much worse than a sure thing (the danger of this belief can be witnessed at any lottery ticket kiosk). Second, people treat chances of winning something much differently than chances of avoiding the loss of something (e.g., we usually have to offer the chance of winning at least $250 to entice people to accept a chance of losing $100). And third, people judge these wins and losses not in absolute terms, but relative to where they expected to be, or where they told other people that they’d be (their reference or anchor point). (cont’d)
How to Achieve Good Returns
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