Our minds are constantly playing tricks on us. Studies show that we process the information we receive from the world through a filter that includes all sorts of biases many of which we are rarely conscious of. A good example of this is the famed black and white image of the Rubin vase, which represents an ambiguous shape that can be seen as either a vase or as two faces. In this same way, our minds can interpret the same input in a multitude of different ways based on our preconceived biases.
Biases can be classified as cognitive, which means a ‘rule of thumb’ is assumed that isn’t necessarily factual, or emotional, which means an action is guided only by feeling. Often a bias is a combination of both.
The biases listed below are commonly identified in investor behaviour – have these shown up for you before?
- Confirmation bias – A confirmation bias is about ‘seeing what you want to see’. People have a tendency to either find information that backs up their own theories, or interpret information in a way that confirms their existing hypothesis. You may recall a friend or family member that quotes the same outdated statistic each time a topic is discussed – this is an example of confirmation bias. Interestingly, confirmation bias also means that where information does not agree with our preconceived ideas, we tend to give it less weight or ignore it, whilst information that is favourable to us is given more weight than it is perhaps due.
- Optimism bias – Also known as unrealistic or comparative bias, optimism bias causes people to assume that they are less likely to experience a negative outcome than others. Both neuroscience and social science suggests that people are more likely to be optimistic than realistic, so the optimism bias is a common trend amongst investors.
- Loss aversion – Loss aversion refers to the tendency for investors to prefer avoiding losses more than acquiring gains. The interesting aspect of loss aversion in investors is that there is not only a preference, but a greater satisfaction gained from avoiding a loss than perhaps accruing a return. This bias has been strongly linked to risk aversion, whereby an investor chooses the investment option with the least amount of risk without due consideration to the likely returns. You will sometimes see people happy to sell an investment that has made money, to lock in the gain, and retain investments that have lost money.
- Recency bias – This is the tendency for people to think that recent occurrences predict what will happen in the future. Often this is because it is easier to remember the events that have happened recently and relate our present circumstances to them, rather than to recall how things have unfolded over a medium or longer term. Though not on purpose, those with recency bias are likely to take a short-term view and may find it difficult to consider investments over a longer term horizon.
- Herding – Made famous by the actions of investors during times of financial crises like the GFC, herding refers to the tendency for people to follow the actions of a larger group, whether those actions are rational or not. Psychologists claim that herding is motivated by a desire to belong to a larger group of people and the assumption that it is unlikely for a large group of people to get something wrong. When it comes to investment, this could result in holding an investment for too long or alternatively selling an investment prematurely, due to the influence of other investors’ actions.
Investors often have more than one bias and decisions can be affected by a combination of tendencies and preconceived ideas. Let’s look at a case study of how the above biases might play out in an investment decision.
Scenario: An investor is considering a new investment strategy with anticipated high returns.
- An investor with confirmation bias is likely to make a decision based on how the asset relates to their personal theory on the state of the investment market.
- An investor with optimism bias might see the investment as a new and unique asset that is likely to provide higher returns than the rest of their portfolio.
- An investor with loss aversion may be sceptical about the new investment due to the level of risk and decide instead to invest the money into a lower risk asset.
- An investor with recency bias will most likely recall the performance of their last few investments and use this information to make assumptions about how the new investment is likely to perform.
- And an investor that is biased towards herding is likely to find out whether other people decide to invest in this new strategy and make a decision based on how many others are also doing so.
Whilst we are all likely to tend towards one bias or another, following a sound financial plan, giving due consideration to your financial goals and investment strategy, and discussing your investment choices with your financial adviser are a good place to start overcoming them.