What are behavioural finance biases? And how to avoid them

Investors can often behave in innocent, but unwise ways that can derail even the best laid financial plans. These behavioural finance biases are part of the cognitive biases that we all have. By some counts, there are dozens of them: some interact, others overlap, and certain biases even directly contradict others.

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In this article, we discuss the many investment biases that can impair our financial decision making and suggest simple steps to help you overcome them.

Common behavioural finance biases

Anchoring

This is an over-reliance on the first piece of information you hear and how it can impact your subsequent decisions. It’s the phenomenon behind the notion that in a salary negotiation, whoever makes the first offer establishes the range of reasonable options in the other’s mind. 

Anchors are everywhere in investing: analyst price targets, recent price ranges, high water marks, moving averages and, of course, your buy price. These can all influence your perception of an investment’s fair value. 

Because comprehensive analysis is difficult and time consuming, investors can be over-reliant on anchors. Even stock analysts can have this investment bias, as they’re often anchored by their previous ratings because it is much easier to rate a stock relative to its previous price than to start in-depth analysis from scratch. 

Confirmation bias and commitment bias 

Confirmation bias is perhaps the most widely recognized investment bias. It’s not just a behavioural finance bias but also occurs in other areas of our lives. It’s the tendency to give too much weight to information that supports our preconceptions, while discounting information that isn’t supportive.

Also, the more people you’ve told of your decision (such as to buy a particular stock), the more likely you are to resist changing your opinion: this is called commitment bias.

Clustering illusion

This is the tendency to see patterns in random events (such as your favourite stock going up in price 15 days in a row). Sometimes this is referred to as the sharpshooter effect, an allusion to pulling patterns out of data and then painting targets around them after the event.

This happens often in gambling. If red turns up on a roulette wheel a number of times in a consecutive string, people may feel that is more or less likely to turn up again, even though the odds that it will be red are always 50:50.

This is an important concept to keep in mind when watching stock price movements: just because the last few days were up or down, doesn’t necessarily imply anything about the likely direction of the next move. 

Recency

Momentum trading is a special manifestation of recency. In more general terms, recency is simply an investment bias whereby more weight is given to the latest information received, and less weight to older data. Recency comes down to allowing our decision-making to be biased by the order in which information is presented to us.

Some of us find it easier to remember the last numbers in a list (recency), others the first (anchoring or primacy effect). Recency can make investors believe the market will always look the way it does today, which can lead to unwise decisions. 

Availability bias 

Some people rely too much on information that is easily available. Availability bias can be considered as a reluctance to undertake thorough research, which can be due to the huge choice of stocks and funds available: investors often only consider assets that are brought to their attention.

There are dangers to impulsively buying a fund or stock because you saw an advertisement for it, and there are no excuses for this investor bias, given the tools available to make informed decisions. 

Endowment bias and choice supportive bias 

Also called the status quo bias or mere ownership effect, endowment bias describes how people overvalue something they already own. Research has shown how owners value their possessions far more than potential purchasers.

Every security in a portfolio should be re-evaluated on a regular basis with your advisor, but this can become difficult because of choice supportive bias (the tendency to feel positive about something because you chose it).

This behavioural finance bias is even stronger with investors and advisors who built their own portfolios: they can believe their home-built portfolios are better than those created by investment professionals who use sophisticated qualitative tools, massive data resources and modern portfolio theory. Yet they wouldn’t expect to beat a professional basketball player in a pickup game.

Optimism bias and overconfidence

Optimism and its cousin, confidence, propel us forward each day; but there is such a thing as being too optimistic. This can lead us to overestimate our knowledge and skill (most investors think they are above-average investors) and therefore take greater risks (such as trading too often and neglecting proper diversification).

Excessive trading is a behavioural finance bias that’s proven to deliver sub-par performance. Sometimes active trading looks like performance chasing, but it’s often driven by overconfidence.

Hindsight bias and attribution bias 

Hindsight bias is the tendency to rewrite history to make ourselves look good. Investors often misremember the information and decision-making processes that led to an investment purchase in ways that make them look smarter. This bias of believing past events were more easily predictable is prevalent in the financial industry: few predicted the 2008 financial crisis, yet many today claim it was obvious.

When we look back at events, it can become difficult to imagine alternatives, even if those alternatives were what was expected at the time.

Attribution bias is hindsight bias’s close cousin. When an investment decision succeeds, we’re quick to attribute that success to our skill: when things go wrong, we blame outside causes.

These investment biases prevent us from learning from our mistakes. If we can’t critically assess our past decisions, we won’t be able to avoid overconfidence in future decision-making. Another consequence that can arise from hindsight bias is regret. Believing the past was more predictable than it actually was can lead to regret, which can cause investors to stop investing altogether.

Outcome bias

This is the process of judging the wisdom of a decision based on its outcome, rather than how the decision was made. Like hindsight and attribution biases, outcome bias is dangerous in that it can lead to overconfidence and reckless decisions. 

How to overcome investment biases

There are several steps you can take to help you avoid behavioural finance biases and invest more wisely.

Do your homework

There is one further behavioural finance bias worth mentioning: the blind spot bias. Most people notice investment biases much more in others than they do in themselves. Failing to recognize your own biases is itself a bias. Nobel Prize-winning physicist Richard Feynman noted that, “The first principle is that you must not fool yourself — and you are the easiest person to fool.”

Education is an essential tool in recognizing and overcoming your own blind spot bias (for example, realizing that your excessive trading is a sign of overconfidence). You’re more likely to adopt some of the tips listed here to correct it.

Acquiring as much relevant information as you can before making decisions is a powerful way to avoid many investment biases. The more time we take to analyze, the less likely we are to revert to biased shortcuts.

Learning about the long-term performance trends of various asset classes is a good place to start, as it can help you set realistic expectations for your investment plan. 

Don’t attach too much significance to short-term results 

Chasing performance is a type of recency bias. Following the herd rarely pays off, because the players with far greater resources than you have probably identified and exploited the pattern long before you noticed it.

Many astute investment professionals suggest that being a contrarian is a wise choice. Warren Buffett said, “Be fearful when others are greedy, and be greedy when others are fearful.”

Remember that your portfolio has been carefully crafted with your advisor to achieve specific goals and objectives over a period of time, with an acceptable level of risk, taking into account your personal goals. It makes no sense to ditch it because of short-term fluctuations.

Don’t check your portfolio too often: you’ll see more short-term losses and be more likely to make poor decisions. One of the key goals of investing is to dampen volatility and reduce risk through asset class diversification, which should be assessed over a sufficiently long time period. This will reduce the influence of anchors.

Seek out alternative scenarios

It can be helpful to be your own devil’s advocate and argue the other side’s case. Being able to appreciate other points of view will clarify your own thinking and help you avoid investment biases.

One way to do this is to plot out your decision-making process and identify each step where you had to make a choice. This will help you to consider alternative scenarios and mitigate confirmation bias.

Mistrust any conclusion drawn from selective data 

Seek out as much relevant information as you can but be watchful for the possible influence of the clustering illusion and availability bias mentioned earlier. Whenever you’re considering recommendations from market analysts, friends, journalists or even financial professionals, examine the depth of research behind them.

Keep an investment log

Track your personal hits and misses, along with the ideas you didn’t act on. By continually revisiting your past investment decisions, you can better understand what drives your investing behaviour and avoid behavioural finance biases.

By keeping track of your mistakes, you’ll discover if they were due to bad luck or an error in your process that can be corrected. 

Don’t react to noise

Anything you see in the media is just one data point, so don’t consider acting until you’ve carefully considered others. Remember that many television segments and commentaries are designed to excite or incite, not to educate.

If you do consider reacting, talk to your advisor first: together you’re more likely to avoid investor bias and thereby make better decisions.

Trade less 

Every trade has a winner and a loser. Both parties think they are going to win, so one has to be wrong, which is a clear sign of overconfidence in one of them. After fees, commissions and spread, the net gain may be negative, so rational investors don’t trade too often. 

Use trading rules

One way to take emotion out of the equation is to use trading rules, based on criteria such as profitability or financial stability (for example, selling an asset if profit margins dip below a certain threshold). This way, you can fall back on rules that are based on solid data, rather than reacting to emotional considerations. 

Don’t go bragging about your great stock and fund picks 

Broadcasting your choices only enhances the emotional investment that results in commitment bias, which prevents you from re-evaluating those choices later. Instead, recommend the services of the investment advisor who helped you thoughtfully and rationally achieve those results. 

Use your advisor

A financial planner is your impartial second set of eyes and can counter all the biases listed above. An advisor can help you set realistic return expectations and take advantage of resources to encourage knowledgeable and wise decision making. 

Partnering with your advisor can also prevent the active trading that results in poor performance. The act of discussing and planning for your retirement can help mitigate the overconfidence and optimism biases that can prevent wise investment decisions and also be an effective way for you to focus on the need to save and invest now.

Talk to an IG advisor regularly to mitigate the risk of adopting behavioural finance biases. If you don’t have one, you can find an IG advisor here

 

Written and published by IG Wealth Management as a general source of information only, believed to be accurate as of the date of publishing.  Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice.