Investor psychology - Cognitive and emotional biases

Whenever people do an analysis or make judgements on anything, whether that be people we know or just met, opinions on social issues, our day to day jobs,  government policies, central bank actions, stock market prices, or any number of other things, we filter these things through a database of our own knowledge and experiences.  This process of personalizing our views opens us all up to various cognitive and emotional biases.

A cognitive bias can be defined as basic statistical, information processing, or memory errors that are common to all human beings.

An emotional bias can be defined as an emotional state that arises spontaneously, often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, whether in reality or the imagination.

I thought it would be informative to go through some of the most common biases and discuss how they could be affecting peoples decision making processes with respect to investing.  Being aware they exist and identifying them may allow us in certain instances to create some ground rules for investing that may mitigate the potential damage caused by acting on biased opinions.

Confirmation bias –  Selective perception in which people emphasize ideas that confirm their beliefs and discount ideas that contradict them.  All too often we investors go out seeking confirmation of our investment thesis rather than seek out opinions or reports that may poke holes in our ideas.  It’s not hard to see though the importance of getting both sides of the story to make a clear and unbiased decision.

Representativeness bias –  Humans have an innate desire to stay organized and over time we develop systems of classifying objects and thoughts within broad categories. Often times investors will categorize investment opportunities as good simply because it represents certain characteristics of other good investments, or vice versa.  An example might be buying a certain dividend stock without really doing any analysis, simply because your brain has classified “dividend stocks” as good investments.  Or not being willing to trade certain proven effective option strategies simply because some other option strategies are classified in your brain as “risky.”

Anchoring bias –  Basing judgements on familiar reference points that may be inaccurate or irrelevant to the problem at hand.  An example might be a person who had a previous price target for a security.  It can be hard to assess the current state without allowing this previous anchor price to influence future decisions, even though it may not have any relevance on the current situation.  Also being attached or anchored to ones own “cost basis” can be detrimental to an objective analysis of the security.

Availability bias –  A heuristic that allows people to estimate the probability of an outcome based on how familiar that outcome appears in their own lives.  If you ask the average person what’s more likely, being killed in a shark attack or by falling airplane parts, most people will say the shark attack because of fear and media attention given to these attacks.  Yet in actuality 20 times more fatalities are caused by falling airplane parts (go figure right?).  Another example is when people regularly see advertising and marketing for certain investment products, they automatically assume they are good simply because the information is so readily available.  Other much better products aren’t “available” to them because they don’t come across them in their day to day lives.

Self attribution bias –  The tendency of individuals to ascribe success to personal traits, and failure to outside agencies.  Let’s be honest, who isn’t guilty of this one?  As investors though it’s important for us not only to have more winning trades than losing ones, but also to understand exactly why those trades were successful in the first place.  If it wasn’t us, and was simply because of a trending market, it’s valuable information to know that.  The classic saying, “everybody is a genius in a bull market” applies here.  If people think they are making money because of their incredible abilities, they may be in for a rude awakening when the markets change direction on them.

Mental accounting bias –  A tendency to make different decisions depending on what mental category it has been classified in.  For example, people are far more likely to take increased risks with money they have mentally accounted for as “found money” rather than “earned money.”  A person walking into a casino with their paycheck might be more cautious than a person who just won an equal amount of money in a lucky draw of some kind.  A person dividing up their investment portfolio as “core” and “speculative” or “safe” and “risky” would also make dramatically different decisions in each mental account, even though it’s the same money coming from the same place.

Negativity bias –  The tendency to cling to negative news and events rather than positive ones.  It’s pretty clear we are in the midst of a generationally strong bull market, yet many people have been left on the sidelines due to negativity bias.  Turn on the TV and it won’t take you two minutes before you see some so called expert telling everybody it’s all going to collapse and end in tears.  Avoiding negativity bias might allow people to participate in market rallies like the one we’re in.  Being mindful of risk is prudent, but risk can be mitigated with diversification, hedging, and stop losses.  Negativity bias scaring people to the sidelines has proven far more costly for many in the last few years.

Recency bias –  Causes people to recall and emphasize recent events more prominently that those in the past.  An example of this would be investors who focus more on recent price movements rather than an overall fundamental analysis.  A stock that is in a recent uptrend in price might be overvalued based on fundamentals, but the recency bias would lead investors to hang on to that investment for too long.  Or even worse, purchase it when it’s at a price peak because recency bias has made them want to not miss out on that high flying stock.  On the flip side, it would stop investors from buying fundamentally undervalued stocks due to a recent downward trend in price, which as it turns out is one of the best long term strategies.  Recency bias often forces people into the dreaded “buy high, sell low” trap.

Endowment bias –  Placing more value on assets we own or have rights to compared to the ones we don’t.  Standard economic theory would say that the price a person is willing to pay should be roughly equal to the price they would be willing to sell at.  Yet endowment bias usually means the price at which people are willing to sell securities they already own is often higher than the price they would buy it at if they didn’t.  What they almost always find is, once they do muster the courage to sell a losing position, they very quickly realize they wouldn’t buy it back again at that same price.  Endowment bias made them value it much higher then a pair of fresh eyes would have.

Self control bias  –  This could also be called the lack of self control, which is just a tendency to consume today at the expense of saving for tomorrow.  Assume a person knows that they need to pay 7,200$ in taxes next year.  Would they rather receive their full paycheck every month and save 600$ per month themselves, or would they rather just have their employer withhold the 600$ for them to pay the tax bill when it comes due?  Common sense would say you’d be better off saving it yourself, because you could place the monthly savings in an interest bearing account and actually have more than the 7,200$ at the end of the year.  Yet most people would much rather just have the taxes withheld due to a lack of self control.

Loss aversion bias –  People generally feel a much stronger impulse to avoid losses rather than acquire gains. Studies have shown that losses have twice the motivational power as potential for gains.  If a riskier investment can’t pay at least double the potential loss, many people won’t entertain it.  Yet this 2:1 ratio often doesn’t make any statistical sense and interferes with the investing process.  As they say, sometimes the best defense is a good offense, but loss aversion interferes with the risk / reward structure of certain investments.  Another variation is regret aversion bias which stops certain people from selling losing positions because they have a hard time facing the reality of realized losses, yet those same people have no problem taking profits too early on good investments.

Status quo bias –  When faced with a wide variety of choices to change course or alter a strategy, many people feel more comfortable just keeping things as they are, maintaining the status quo.  It can also cause investors to hold securities they feel comfortable with or emotionally attached to, regardless of whether they are fundamentally sound.  It’s very common for people to site the reason they hold on to certain stocks is because “they’ve been good to me.”  Well, are you sure?  Are you sure maintaining the status quo hasn’t stopped you from entertaining potentially better alternatives?

Bandwagon bias –  The tendency to do or believe things because many other people do.  By now everybody is likely aware of the tremendous investing success of Warren Buffet over the years, and more then that, many people are also aware of his famous quote:  “Be fearful when others are greedy, and greedy when others are fearful.”  Yet that doesn’t stop many of us from falling victim to bandwagon bias anyway.

There are many more biases that we humans fall victim to.  What we find when studying the methods of some of the world’s most successful investors isn’t that they don’t also fall victim to all the same biases, because they do.  What we find is most of them have developed certain trading rules and strategies that help them successfully navigate the minefield that is cognitive and emotional biases.  Investor psychology is just as important as having a fundamental understanding of the markets, and being aware of these biases gives us an edge in the competitive world of trading.

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