Figure 1. Dollar-Cost Averaging

Dollar-cost averaging is the practice of investing equal dollar amounts over a period of time. In the example shown below, $1,000 purchases of a stock are made at different intervals. When the share price is higher, fewer shares are purchased. When the share price is lower, more shares are purchased. The same practice can be used for selling, with a portion of the position sold at various time intervals instead of the entire position being sold at once. In both cases, the risk of buying or selling at the wrong time is diminished. It also gives you the flexibility to change your opinion should new information come to light. An additional benefit is reducing the likelihood of moving the share price with your buy or sell orders when trading in a lower-volume stock.

Figure 2. Risk Aversion Can Lead to Suboptimal Decisions

Prospect theory holds that humans overweight the probability of losing money relative to the same probability of making money. This can cause investors to make suboptimal decisions, and thereby realize lower portfolio returns by attempting to avoid or limit losses.

This often leads an investor to embrace one strategy above all others: Don’t lose money! This may cause an investor to sell immediately at the first sign of a loss or worse, to hold on blindly when the price declines in the hope of breaking even when it rebounds.

Holding a losing position is always challenging—what should you do? Generally, if something happens that seriously disrupts our thesis on a long-term basis, we’ll sell all or part of our position depending on its size. We can always revisit the investment later. However, if the price is down but the investment thesis remains intact, we’ll hold and perhaps buy more at bargain prices.

Common Behavioral Biases

These common behavioral biases often bedevil investors and make it more difficult to deal with the pain of investing.

Confirmation Bias

This occurs when we embrace a narrative or rhetoric that confirms our thesis while ignoring the facts or evidence that challenge our thesis. Keep an open mind and always try to identify perception versus reality. You want to invest on the basis of facts, reasoning and logic and always be aware of events that may dissuade your thinking from these key tenants.

Loss Aversion Bias

For some reason, investors often find losses to be much more painful relative to the joy realized from a gain of an equivalent amount. Losing $100 feels twice as bad as gaining $100 as illustrated in Figure 2.

Recency Bias

Investors have a tendency to think what happened recently will continue to happen. Stocks that are going up will continue to go up while those declining will continue to fall. Past performance can be a strong driver of investor behavior—buying a particular stock, fund or asset class that’s gone up generally feels good, at least in the short term.

All of us are social animals and like to go to the most popular movies, concerts, restaurants or sporting events. This is fine when it comes to entertainment but applying the same behavior to investing can lead investors to buy when the market or a stock is high and sell when it’s low. So, before you take action on an investment, stop and assess whether the actions of others are right for you and only then proceed.

Disposition Bias

This occurs when an investor “disposes” of a winning position to make up for prior losses. This may result in taking a profit when it’s best to hold on. Assess each position independently. Take gains if necessary for good reasons, but don’t focus on taking gains just to offset losses especially since those losses can be used to offset other income for tax purposes.

Familiarity Bias

Investors commonly exhibit a preference for familiar or well-known investments while ignoring unfamiliar investments beyond their comfort zone. While it’s important to stay within one’s circle of competence, it’s also important to stay open to new ideas.

Our universe of potential investment ideas is probably a couple hundred firms—all of which we would purchase at the right price. We are very familiar with each company on the list, but that doesn’t stop us from looking at unfamiliar names that come to our attention. Often, after proper due diligence, we understand these unfamiliar names and they are added to our universe with the intention of placing them in the portfolio under the right circumstances.

Anchoring Bias

This is our tendency to rely heavily on or anchor to a past reference or piece of information in making a decision. Perhaps an investor has an emotional tie to a certain stock that was received as an inheritance, gift or employment benefit. While the emotional bond may be strong and the tax basis low, investors should carefully monitor such positions to avoid unpleasant “surprises.”

For some investors, an obvious anchor is the share price. An investor sitting on a loss may vow to sell as soon as the share price returns to breakeven. By doing so, they give up further gains as the share price moves higher.

Alternatively, an investor may refuse to buy until the price returns to a prior low and completely misses the upside when the stock doesn’t retest the bottom. Remember, the past share price provides no indication of whether the stock is currently a good value. Only the current share price compared to company fundamentals will tell you that.

Hindsight Bias

Our tendency to brood over past losses can often prevent us from objectively analyzing opportunities going forward. We all make investing mistakes. The important thing is to learn from what we did wrong and move forward. While we often analyze our mistakes to pinpoint what went wrong, dwelling on past losses is counterproductive.

Oversimplification Bias

Most investors want a clear and simple explanation of why to buy a stock. Unfortunately, it’s not always so easy. Modern life is increasingly complex and so is investing. Complexity and uncertainty are part of investing. It’s important not to oversimplify or rationalize the decision in order to justify an investment.

Sometimes an idea is just “too hard” to understand. In such cases, we won’t waste time trying to do so. However, one of the joys of security analysis is learning new things and we relish every opportunity to do so.

Availability Bias

Investors often misjudge risks when they rely too heavily on readily available information and underweight the importance of information that isn’t readily available. The internet has made reams of data publicly available, some of it true, some not. Just because you saw it on the internet does not make it true. Check the source. Ask whether it is reputable.

We always try to prioritize true information that is fresh in our mind over information we learned a while ago that we thought at the time was highly relevant. Perhaps it is still relevant but needs to be augmented with more recent information to provide a more accurate picture. We always try to filter out the “noise” to focus on what is knowable AND important.

Action Bias

Most of us are wired for action and sitting on our hands often makes us feel uncomfortable. This often leads us to embrace what’s trending rather than what’s a good value. Resist making portfolio changes just to act, do your homework and invest in companies that you know well for the long term.