Unlike traditional finance models, which assume that investors always make perfectly rational decisions based on all available information, behavioral finance recognizes that we as humans make mistakes. Generally these mistakes are a result of our limited cognitive abilities (cognitive biases) or emotional tendencies (emotional biases).
Cognitive biases stem from statistical, information processing, or memory errors. For example, investors may fail to update probabilities (especially within a Bayesian framework) or they may not gather and properly consider all relevant information. Instead, investors gather what they believe is sufficient information and apply heuristics to analyze and shape the information. The result is faulty reasoning and decisions that are not optimal from a traditional finance perspective.
Cognitive biases are grouped into two categories: belief perseverance and information processing. Belief perseverance bias occurs when investors clings to their previously held beliefs despite contradictory information. One example would be an investor ignoring information that conflicts with their view or only remembering information that confirms existing beliefs. Information processing biases occur when an investor sorts and processes information illogically.
Unlike the deliberate nature of cognitive biases, emotional biases are more of a spontaneous reaction in an attempt to satisfy basic human desires of avoiding pain and producing pleasure. The psychological predispositions that cause investors to irrationally frame information or a decision are harder to correct for than cognitive errors.
Below are brief descriptions of five biases I frequently see among individual investors. Read them carefully and try to identify the biases that you may experience in your own investing.
1. Overconfidence Bias
This causes investors to overestimate the quality of their judgment or information. Some investors believe they can successfully predict market downturns and rallies. Others perceive themselves to have a knowledge advantage when they get a tip from someone in finance or read information from a publication or research report.
Several studies have shown that overconfidence bias leads investors to trade more frequently in an effort to align their positions with current market conditions. The cost of frequent trading eats into returns, and rarely are the returns big enough to make up the difference. These investors are also very susceptible to forgetting the times they were incorrect or recognizing the role luck played in positive outcomes.
2. Confirmation Bias
This is the tendency for investors to seek information that supports their decision or thesis and avoid/ignore information that contradicts it. For example, an investor gets an investment tip from a friend and decides to do some research. While doing research, investors often find all sorts of positives while glossing over the red flags in trying to "confirm" the return potential of the investment. As a result, this bias results in a poor, one-sided decision making process. This bias also occurs to many investors with investments they've made recently as people don't like acknowledging devaluing evidence that might discount their claims.
Another example is an investor that only invests in companies that pay dividends. This investor associates non-dividend-paying stocks with unsafe or unprofitable investments, but ignores the economic reality that a high-yielding stock may be a sign of trouble. In disregarding all stocks that don't pay dividends, the investor also may miss out on companies that trade at better valuations and run businesses with superior competitive advantages.
3. Loss Aversion Bias
Kahneman and Tversky found that humans feel the pain of a loss about twice as much as they feel the pleasure of the same sized gain. Consequently, investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss.
Checking your portfolio too frequently can make you more susceptible to loss aversion because the probability of seeing a loss in a short time period is much greater than over longer time periods. As a result, investors that frequently check their portfolio tend to take a less than optimal amount of risk. In other words, true long-term investors are more willing to allocate towards risky assets because they don't care about the short-term ups and downs.
Holding a portfolio for long enough allows you to increase the probability of a positive return. As a result, the best way to prevent loss aversion is creating an asset allocation that meets your long-term goals and sticking to it through unbiased rebalancing.
4. Anchoring Bias
This occurs when investors make a buy or sell decision based on purchase points or arbitrary price levels. Consider purchasing a stock at $75 that surges to $100 after the announcement of positive economic data that is expected to increase future earnings of the stock. You consider selling at this point, but ultimately decide not to. Over the next three months, the stock declines to $85 as the economic details look less promising than initially expected.
Investors suffering from anchoring bias will resist selling until the price rebounds to the $100 price point it achieved three months ago. These investors are not considering that the stock may have deteriorating fundamentals and, consequently, never return to the previous price point. The above example is very specific, but I see various anchoring bias scenarios among investors all the time.
5. Endowment Bias
When evaluating an investment, investors place a higher value on an investment they already hold than they would if they didn't own the asset and had the potential to acquire it. Investors are thought to hold investments for various reasons such as familiarity with a position or to avoid transaction and tax costs. As a result, investors place an irrational premium in the desired selling price of an asset.
A common example of this bias occurs when an investor is holding a big position in an inherited security. Investors may be reluctant to sell a specific security because they feel disloyal to loved ones or uncertain about making the right decision financially. The question to ask yourself in this situation is: If you had received the current value of the security in cash, what portion of that inheritance would you allocate into this specific security?
This bias is not only limited to investment securities. Real estate owners also often set minimum selling prices for assets they currently own that are higher than the maximum price they would be willing to pay to purchase the asset themselves.