• Outcome bias. This causes investors to focus on past events, such as returns from a stock in recent years, rather than observing the events that created these outcomes and looking for differences. In the 1990s, people clung to the notion that past returns from tech stocks would continue indefinitely. But they ignored the high valuation bubble that this assumption had created and got stung when prices plummeted in 2000.
• Recency bias. This mind-set causes people to emphasize events of the recent past rather than those from long before. By believing that the future will likely resemble the recent past, they're seeking to defy the greater odds that the future will more likely resemble the long-term past average. This can cause an employee to ignore the fundamentals of his company and begin to chant the dangerous words "this time it's different" as they ignore historical facts about industry bubbles and peaks.
• Illusion-of-control bias. Some investors believe they can control outcomes when, of course, they can't. Employees who work hard to build a company are inclined to be concentrated in its stock whose fate they feel they control. Often that control proves illusory. In a capitalistic society we have seen the forces of competition wreak havoc on companies that many thought were safe and stable.
• Availability bias, or overestimating the likelihood of an outcome based on how familiar that outcome seems given the information that's available. Employees in a given industry are often focused on success stories and fail to look at companies in the same industry that fail. High-tech growth companies such as Google or Amazon are much more conspicuous than forgotten failures like webvan or etoys.
More recently, did employees of companies in the mercurial cell phone industry invest too heavily in their own company stock? This industry has over the years has seen a number of booms and busts and leadership seems to be ephemeral. Many of these companies have their day in the sun and as projections of the future become overly ambitious eventually the stocks come crashing down to earth like Icarus. If you were an employee of Apple you may feel like a genius today but what about the employees of Motorola, Research In Motion and Nokia? Didn't they used to have some of the hottest phones on the market?
Many of these people likely fell victim to recency or outcome bias--assuming that past successes would necessarily repeat.
The key is to open your mind to negative news concerning the stock you've loaded up on and stay objective. This negative news may end as a tsunami, but it doesn't start that way. It starts as one ripple after another. Savvy investors are attuned to these ripples, watching for the point where they turn into rising waves. Any winning portfolio contains losing stocks; it's the average performance that counts, relative to the weighting of different stocks.
So when you get ready to load up on your company stock, look inward to see if you are doing so out of behavioral bias. If your knowledge of the company or your identification with it were the same as it is for the typical stocks in your portfolio, would you be inclined to buy so much of it? If you've already pulled the trigger and bought a lot of this stock and it has been sliding for too long, be willing to admit that you're human.
Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.