Investing Biases

2015-03-31

A bias can be described as an inclination that inhibits impartial judgment. Every day we make decisions based on facts and biases, often without even realizing it. Some biases are helpful, while others have potential to be harmful.

In the investment realm, behavioral biases are defined as systematic errors in financial judgment or imperfections in the perception of economic reality. As an investor, it’s important to be aware of biases. Recognizing your ‘blind spots’ and emotive thought processes will greatly improve your potential to achieve your investment goals and assist in the avoidance of many common investing errors.

Biases can be separated into two groups: cognitive and emotional

Cognitive Biases:

  • are a tendency to think in certain ways;
  • are often referred to as a ‘blind spots’, stemming from illogical or faulty reasoning, or distortions in the human mind;
  • can yield irrational judgments;
  • can often be corrected utilizing substantiated information.

Emotional Biases:

  • are on the opposite side of the spectrum of illogical or distorted reasoning;
  • are a mental state that arises spontaneously, rather than through conscious effort;
  • can yield irrational judgments;
  • can be identified and recognized through practice, enabling individuals to learn to alter behaviours.

Emotions can be undesirable to the individual experiencing them. We may wish to control our own emotions but often we’re unable to. When investors are presented with investment choices, sub-optimal decisions can result if their emotions are permitted to interfere with their decision-making abilities. When subjected to large volumes of information and data, many investors opt for more simplified information processing in an attempt to make sense of it all.

To follow is a list of 20 behavioural biases (14 cognitive and 6 emotional). Becoming aware of our personal biases not only helps us to effect change, it also serves to ensure that we’re making the right decisions for the right reasons … not just for investing, but also in daily life.

Cognitive Biases

1. Overconfidence

Overconfidence is defined generally as unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities. Many of us tend to overestimate both our predictive abilities as well as the precision of the information we have been given. Sometimes people realize that events ‘thought to be certain to happen’ do not occur, but they don’t learn from these mistakes.

In the investing realm, people tend to think that they are smarter and have better information than they actually do. For example, an investor may get a stock tip and make an investment based on his/her perceived knowledge advantage.

2. Representativeness

As human beings, we like to stay organized. Over time, we develop an internal system for classifying objects and thoughts. When confronted with new circumstances that may be inconsistent with our existing classifications, we often rely on a ‘best fit’ process to determine into which category we should classify the new circumstance. This perceptual framework provides a practical tool for processing new information by simultaneously incorporating insights gained from past experiences. New stimuli may seem similar but in reality there are differences. In other words the classification reflex is wrong, and produces an incorrect understanding of the new element.

In the investment realm, we may be presented with an investment opportunity that contains some elements representative of a good investment. We may classify what is really a poor investment opportunity as a good one, based on the few elements that are representative of a good investment opportunity.

3. Anchoring and Adjustment

If a person is asked to estimate a value in an area that they have little or no familiarity with, such as the distance to the moon, and are presented with an initial default number (an anchor) then they typically adjust up or down to reflect subsequent information and analysis. The anchor, once fine-tuned and re-assessed, can sometimes mature into a final estimate. People are generally better at estimating relative comparisons rather than absolute figures.

The following example illustrates how this works in the investment world. Suppose an investor is asked whether the Dow Jones Market Index will be greater or less than 11,000 next year. Obviously, the answer will be either above 11,000 or below 11,000. If the investor was then asked to guess an absolute value of the index next year, the estimate would probably fall somewhere near 11,000 because the estimate is likely subject to anchoring by the previous response.

4. Cognitive Dissonance

When people are presented with information that conflicts with pre-existing beliefs, they usually experience mental discomfort, commonly referred to as cognitive dissonance. Cognitions, in psychology, represent attitudes, emotions, beliefs or values. Cognitive dissonance is a state of mental imbalance that occurs when contradictory cognitions bump into one another. The term encompasses the response that arises as people struggle to relieve their mental discomfort by trying to get conflicting cognitions to align. For example, an investor might invest in stock ABC, initially believing that it is the best stock available. However, when a new cognition that favors a substitute stock is presented, an imbalance occurs. Cognitive dissonance takes over in an attempt to relieve the discomfort with the notion that perhaps the investor did not purchase the best stock. People will go to great lengths to convince themselves they made the right decision, to avoid mental discomfort associated with their initial investment.

5. Availability

The availability bias is a heuristic that allows people to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives. People exhibiting availability bias perceive easily recalled possibilities as being more likely than outcomes that are harder to imagine or difficult to comprehend. One classic example cites the tendency of most people to guess that shark attacks cause fatalities more frequently than injuries sustained from falling airplane parts. However, the latter has been shown to be thirty times more likely to occur. Shark attacks are probably assumed to be more prevalent because sharks invoke greater fear, or because shark attacks receive a disproportionate degree of media attention.

Mutual fund advertising is another good example of availability bias. Investors who see a certain company’s advertisements frequently may believe that company is a good mutual fund company, when it’s possible that a company that doesn’t advertise is better.

6. Self-Attribution

Self-attribution bias (also known as self-serving bias) is the tendency of individuals to ascribe their successes to personal traits, such as talent or foresight, and to blame failure on outside influences, such as bad luck. For example, students doing well on an exam might credit their own intelligence or work ethic, while those failing might cite unfair grading. Investors often incorrectly ascribe investment success to themselves, while investment failure is usually someone else’s fault.

7. Illusion of Control

Illusion of control bias is the tendency of individuals to believe that they can control random outcomes when, in reality, they cannot. This bias is often observed in casinos. Some casino patrons swear that they are able to influence a roll of the dice by blowing on them. For example, in the casino game of craps, research has demonstrated that people actually cast the dice more vigorously when they are trying to attain a higher number.

8. Conservatism

Conservatism bias is a mental state in which people cling to a prior view or forecast and do not acknowledge or obtain new information that might change an existing view. For example, say an investor receives bad news regarding a company’s earnings and this news contradicts an earnings estimate issued in the previous month. Conservatism bias may cause the investor to under-react to the new information, maintaining a belief in the previous (more optimistic) estimate, rather than acting on the updated information.

9. Ambiguity Aversion

People avoid making an investment or a decision when probability distributions seem uncertain to them – they hesitate in situations of ambiguity. This can sometimes be referred to ‘analysis paralysis’. We need to realize that not making a decision is a decision in itself and should be evaluated along with the other choices.

10. Mental Accounting

Mental accounting describes people’s tendency to categorize and evaluate economic outcomes by grouping assets into non-fungible (non-interchangeable) mental accounts. Investors irrationally treat various sums of money differently based on where these sums are mentally categorized. The way that money is obtained (work, inheritance, gambling, bonus, and so on) or the nature of the money’s intended use (for example, leisure or necessities) can affect how that money is treated. For example, behavioural economist RH Thaler determined that we are much more likely to risk money we considered ‘found’ than money we consider ‘earned’.

11. Confirmation

Confirmation bias is a type of selective perception in which people emphasize ideas that confirm their beliefs, and discount ideas that contradict their beliefs. For example, a person may believe that people wear more red shirts during the summer than during any other time of the year. This position may be due to confirmation bias, which causes that person simply to notice more red shirts during the summer because he wears red during the summer, while overlooking shirt colours during other months. This tendency, over time, unjustifiably strengthens the belief regarding the summertime concentration of red shirts. Investors may confirm things about a security they want to confirm, such as good earnings, but may overlook negative factors affecting the outcome of an investment.

12. Hindsight

After the outcome of an event is known, some people believe that the outcome was predictable (even if it was not). This happens because actual outcomes are clear in a person’s mind but the myriad outcomes that could have occurred but didn’t, are rather fuzzy. Therefore, people tend to overestimate the accuracy of their own predictions.
Hindsight bias has been demonstrated repeatedly by investors: a stock goes up and an investor feels he ‘knew it all along’, but in fact the outcome was unpredictable.

13. Recency

Recency bias causes people to recall and emphasize recent events more prominently than those that occurred in the near or distant past. This bias is prevalent in investing as well as many other activities. It can cause investors to ignore fundamental value and focus only on recent upward price performance. When a return cycle peaks and recent performance figures are most attractive, it is human nature to chase the promise of a profit. Asset classes become overvalued, and by focusing only on price performance and not on valuation, investors risk principal loss when these investments revert to their mean or long- term averages.

14. Framing

Framing bias is the tendency to respond to various situations differently, based on the context in which a choice is presented (or framed). Everyday evidence of framing bias can be found at the grocery store. Many grocers will price items in multiples – for example, ‘2 for $2’ or ‘3 for $10’. The pricing doesn’t necessarily imply that any kind of bulk discount is being offered. An item priced at ‘3 for $10’ could also be available at a unit price of $3.33.

The optimistic or pessimistic manner in which an investment or asset allocation recommendation is framed can affect people’s willingness to invest. Optimistically worded questions are more likely to be acted upon than negatively worded ones, and optimistically worded answer choices are more likely to be selected than pessimistically phrased alternatives.

Emotional Biases

1. Endowment

People who are subject to endowment bias place more value on an asset they hold property rights to than on an asset they do not hold property rights to. This behavior is inconsistent with standard economic theory, which says that a person’s willingness to pay for goods or an object should be equal to the person’s willingness to sell the goods or object. We often see this when investors continue to hold securities they own rather than disposing of them in favour of better investing opportunities.

2. Self-Control

Self-control bias (really, a lack of self-control) is the tendency to consume today at the expense of saving for tomorrow. Using monthly contributions that are automatically withdrawn from our accounts makes it easier to invest in things like RRSPs and TFSAs rather than putting money aside and making a lump sum deposit in February.

3. Optimism

Empirical studies have demonstrated that with respect to almost any personal trait perceived as positive (good looks, sense of humor, attractive physique, expected longevity and so on) most people tend to rate themselves as surpassing the population mean (the average of all items in a population). This tendency is known as optimism bias.

Investors also tend to be overly optimistic about the markets, the economy, and the potential for positive performance of their investments. Many overly optimistic investors believe that bad investment outcomes will not happen to them but only to other people. However, everyone makes bad investment decisions – even the legendary Warren Buffett.

4. Loss Aversion

People generally feel a stronger impulse to avoid losses than to acquire gains. The possibility of a loss is, on average, twice as powerful a motivator as the possibility of making a gain of equal magnitude. That is, a loss-averse person might demand, at minimum, a two-dollar gain for every one dollar placed at risk. In this scenario, risks that don’t ‘pay double’ are unacceptable.

Loss aversion can prevent people from unloading unprofitable investments, even when they see little to no prospect of a turnaround. Some industry veterans have coined a diagnosis (‘get-even-itis’) to describe this condition whereby a person waits too long for an investment to rebound following a loss.

5. Regret Aversion

People who are subject to regret aversion bias avoid making decisions because they fear, in hindsight, that whatever they decide to do will result in a bad decision. An example of regret aversion is observed when investors hold on to losing positions too long in order to avoid admitting errors and realizing losses. When investors experience negative investment outcomes, they feel instinctually driven to sell – not to press on and snap up potentially undervalued stocks. However, periods of depressed prices often present the greatest buying opportunities. Therefore, people suffering from regret aversion bias hesitate most at moments that actually may merit aggressive behaviour.

6. Status Quo

Status quo bias is an emotional bias that predisposes people, when faced with a wide variety of options, to choose to keep things the same (to maintain the status quo). The scientific principle of inertia, which states that a body at rest shall remain at rest unless acted upon by an outside force, is a similar concept.

Status quo bias can cause investors to hold securities with which they feel familiar or emotionally fond. This behavior can compromise financial goals, because a subjective comfort level with a security may not justify holding onto it despite poor performance.