Biases and sensation seeking: Scott Nations on the mental aspect of investing

Since we’re all human, we all have biases and every investor has to manage the mental aspect of trading. It’s as important as understanding all the financials, the balance sheet and the income statement. And that’s because there are about a dozen biases that investors fall for. And unfortunately, none of them, not a single one, improves investment returns. You would think that just through happenstance, at least some of them would help returns. None of them do. They all hurt returns. And it’s entirely possible for somebody to be a great financial mind and give all that advantage away just by giving away the fact that they have an advantage, by giving that away to biases.

The key psychological attribute to a great investor is to understand their own weaknesses, understand how they become susceptible to certain biases. Which bias are they most susceptible to? For example, I spent 25 years as an option trader in Chicago. The bias I am most susceptible to is overconfidence. And I have experienced all of the biases myself. I’ve seen everyone of them displayed every day. And I think the most important thing to do is to understand that they exist, understand that as a human you’re going to fall for them, and understand which ones you are most susceptible to.

There are practical exercises or tools that investors can use to make sure that they’re reining in their own biases to the degree that that’s possible, and it certainly is possible to a great degree. I think the most important thing is to understand all the biases, be able to express them in just a few sentences, and then to examine them. Now, when it comes to a volatile environment, another bias that we haven’t talked about is sensation seeking. Often investors believe that they should be doing something, that they should be placing some sort of trade, particularly when things are volatile. If you are trading simply because you are seeking sensation, you’re probably better off if you go find a roller coaster and enjoy that sensation, rather than trading simply because you’re seeking the sensation of trading and you feel like that’s something you should be doing.