It’s the second to last day here in Montreal and there is a recurring subject that I have noticed popping up in many of the sessions here at the conference – Behavioral Biases. In the investing world this refers to the psychology behind investor behavior and the effect that widespread decision making can have on markets. As an investor it’s important to understand them because they really do matter.

First, it’s important to understand them in order to avoid them. Investors are constantly being bombarded with new information from every direction. Reacting correctly to new information is difficult for people, so staying disciplined in this area can be hard. But secondly, understanding errors that are commonly made can open up doors to strategies that aim to take advantage of those patterns. Let me use a specific behavioral bias as an example.

Representativeness is a bias showing that in general people are overconfident in their analyses of new information and they tend to ignore the longer run in the process. Sports fans should check out The Hot Hand Fallacy as an example of representativeness.

An example in investing is when individual investors overreact to short term performance of mutual funds. Over very short periods of time money tends to flow into mutual funds that have recently outperformed and flow out of mutual funds that have recently underperformed. This is usually a case where people get excited or worried too quickly. Because of the structure of mutual funds and the way taxes are distributed, large amounts of money moving in and out of mutual funds can have big effects for investors who decide to hold mutual funds for the long term while other people get in and out quickly. Because we approach our investments with a long term horizon, we favor mutual funds that are limited to clients of advisors who tend to have long term outlooks similar to ours. With more shareholders holding that same long term view, the bad behavior is better policed and the shareholders are better served.

While we take steps to avoid the negative effects of this behavioral bias, we are also active to taking advantage of opportunities that come from other’s representativeness. Money tends to move in and out of individual name stocks in the same way they flow in and out of mutual funds. Because across the majority of markets people tend to chase outperforming stocks and avoid underperforming stocks, momentum investing can be a successful strategy. By accepting that people aren’t always entirely rational, we can structure our portfolios to take advantage of both winning and losing stocks in a diversified way that we believe will do well over the long term.

In the end, we aren’t perfect. The truth is, these biases are unavoidable. I challenge you to take a look at this list and exclude yourself from them all. But I think an investor who understands them can work to improve in an incremental way and really make a difference.