The 5 Most Common Patterns of Investor Decision Failure

Investing is one of the most intricate decision-making processes, heavily influenced by psychological biases. Despite the industry's reliance on heuristics, gut feelings, pattern recognition, and complex thought processes, there's surprisingly little discussion on how common psychological phenomena shape investors' decisions.

While achieving complete objectivity in investing may be unrealistic, recognizing and understanding these biases is crucial. By identifying common patterns of bias, investors can better spot and counteract them when they arise.

From my experience as an investor, here are the most common psychological distortions:

1. The Satiation Effect - Don't Do Deals Hungry

The satiation effect is a well-documented phenomenon where satisfaction or interest decreases after a need or desire has been recently fulfilled. Investors are less likely to invest in a company if they’ve recently made an investment compared to after an extended period without one.

Time and again, I've seen the worst deals made when investors are eager for action, driven by a lack of recent activity. Conversely, great opportunities are often overlooked when investors are fatigued from too much deal flow, leading to missed hidden gems. Exciting companies may be dismissed simply because they seem too much work or not worth the effort.

2. Groupthink and Confirmation Bias - “We Don’t Like Those”

Funds often develop internal dogmas based on past successes and failures, reinforced by groupthink (the desire for group consensus) and confirmation bias (interpreting new information to confirm existing beliefs). This results in entire categories being dismissed, with even peers' work in these areas quickly disregarded. Funds start to treat entire categories as dead zones, no longer exploring them and dismissing the work of peers interested in those areas.

3. Competitive Arousal - Revenge Investing

Losing a deal in a competitive process can be deeply painful. The effort invested and the potential high returns are lost, and another investor has won. This competitiveness can lead to "revenge investing"—hastily investing in a competitor or alternative to the lost deal. While the reasons for liking a certain asset may apply to its alternatives, the emotional and hasty decision-making can lead to overlooked specifics that matter. This phenomenon, known as competitive arousal, often degrades decision-making as emotion overwhelms rational thinking.

4. Analysis Paralysis - More Diligence, More Problems

There’s an infinite number of questions one can ask about any given investment, but only a few actually matter. Investors often reach a point of indecision after asking critical questions and, instead of making a decision, seek more information. This additional, often inconsequential, information leads to analysis paralysis—a state where information overload prevents decision-making. Worse, it can cause investors to miss the forest for the trees, fixating on irrelevant details.

5. Wishful Thinking and Overconfidence Bias - This Fits Perfectly in Our Thesis

Investors spend enormous amounts of time building a thesis—a hypothesis about why a certain type of asset is poised for growth. This extensive work can lead to overconfidence bias (overestimating the accuracy of their predictions) and wishful thinking (believing what they wish to be true). They become overly focused on how well an asset fits their thesis rather than the specifics that impact its performance.

What Can Investors Do?

The first step in combating these biases is understanding them. Proactively identifying biases when they occur is crucial.

A more long-term solution involves standardizing key factors that are always considered for every opportunity. While it's impossible to systematize the entire diligence and decision-making process, identifying a few critical points to keep top of mind throughout diligence and standardizing how top-of-funnel deal flow is evaluated can significantly combat human biases.

By recognizing and addressing these psychological biases, investors can make more informed and rational decisions, ultimately leading to better investment outcomes.