How to get past the biases that may be ruining your portfolio

Even oracles make mistakes.

At least, they do in the investment world. And sometimes they're big ones.

Take Warren Buffett. The billionaire known as the Oracle of Omaha recently said his biggest mistake was one that by his estimate has cost him $200-billion (U.S.). The gaffe? Oddly enough, he says it was buying Berkshire Hathaway, the firm he has built into one of the world's biggest, most successful companies.

Mr. Buffett recently said it was a mistake to use Berkshire, which was a struggling textile mill when he bought it in the mid-1960s, as the base for his empire. While other businesses he bought thrived and drove Berkshire's growth, the textile mill itself long acted as a drag on profits. Had Mr. Buffett instead started out with a "good insurance company," he estimates he would now have a firm worth twice Berkshire's $200-billion.

Mr. Buffett isn't alone in making big mistakes. Pimco's Bill Gross - a man known today as the "Bond King" - told CNBC that in 1975 he passed up opportunities to invest in Berkshire Hathaway and Wal-Mart, both of which would later become wildly successful firms.

That Mr. Buffett and Mr. Gross have made big mistakes shouldn't be a surprise. The stock market and economy have far too many moving parts for anyone to be right all the time.

The key to good investing isn't to obsess about avoiding mistakes on every single pick you make. That's impossible. Instead, it's to avoid broader mistakes - in particular, to not fall prey to the self-destructive biases to which all people are predisposed.

What sorts of biases am I talking about? Here's a sampling:

Myopic loss aversion Investors, not wanting to lock in losses, often hold on to losing stocks well after they're no longer attractive. The phenomenon has a biological basis. Studies show that a losing investment causes people about twice as much pain as the good feelings they experience when an investment succeeds.

Anchoring This is when one bases one's expectations on facts that are no longer relevant. Suppose, for example, that Stock A traded for $50 one year ago, fell to $25, and then rebounded to $32. You might think the stock is a bargain because it is still trading below its previous high. That's true, however, only if nothing has changed in the stock's fundamentals - and only if the $50 price a year ago was fair. Still, investors will automatically anchor their expectations to that previous price.

Recency bias People extrapolate the recent past into the future. If oil stocks do well one year, many investors will keep piling into them. They expect more of the same, when they should be basing their decisions on factors like valuations and balance sheets.

Hindsight bias This is more than just realizing how you could have made money (or not lost money) after the fact. It's when we incorrectly think that what we should have done was obvious or easily predictable - and allow that misconception to colour our future decisions.

Expectation bias Studies show that people are more likely to look for facts that support their initial thesis than they are to find evidence to refute it. If you have a good feeling about a stock, you're likely to focus on information that supports that feeling.

These biases are all hardwired into our brains. So, how do we get past them? Here are a few suggestions.

Stick to the numbers Unlike humans, numbers aren't affected by emotions; they don't fear losses, and they don't follow the crowd. By focusing on numbers and avoiding subjective assessments, you let reason and cold, hard data drive your decisions.

Stick to a schedule Many of the biases listed above are particularly strong when it comes to deciding when to sell a stock. But if you use a system in which you update your portfolio only at regularly scheduled intervals, you remove day-to-day emotions from the equation. I rebalance most of my portfolios monthly, selling stocks that no longer rate as highly on my quantitative Guru Strategies, and replacing them with higher-scoring stocks.

Understand history Not knowing your history makes you particularly prone to recency bias. It's easy, for instance, to dwell upon negative headlines. But if you know that back in 1979, Business Week ran a cover story heralding "The Death of Equities," and that just three years later stocks took off and returned almost 20 per cent per year for the rest of the century - well, it puts anti-stock headlines in a much different context.

Follow proven strategies The fundamentals of good investing don't change. My Benjamin Graham-inspired portfolio is based on an approach Mr. Graham outlined more than 60 years ago. By targeting financially sound companies with steady growth and cheap shares, it has averaged annual returns of almost 16 per cent since its mid-2003 inception, while the S&P 500 has gained a little over 2 per cent per year.

Following these tips doesn't guarantee that you'll be right on every stock pick, or that you'll make money all the time. Nothing can do that. But what it does do is stack the odds of success in your favour, by keeping biases at bay. In the long run, that should mean nice profits for your portfolio.