Which investor bias do you have?

Investor biases are irrationalities or limitations in the decision making process. We all have them, yes even the staff at Serpent Stock. They can cloud our judgement, cause unnecessary fear or confidence, or skew our portfolios to suboptimal holdings. By identifying your investor biases it may be possible to compensate the bias or correct the cognitive error in order to improve decision making. At the end of the day that’s exactly what Serpent Stock is about, making our members better investors. Biases can be split into two categories: Emotional Bias, and Cognitive Bias/Error.

Emotional biases originate from the investor’s personality traits and psychological tendencies. These tendencies are not a result of intentional planning; they occur sporadically, circumventing cognitive reason, and are therefore more challenging to fix. Cognitive errors happen due to faulty analysis or incomplete information. Unlike emotional biases, cognitive errors are rational in nature and therefore can be more easily rectified with education and enhanced access to information.

Emotional Biases

Self-Control Bias: This bias is the mismanagement of balancing short term satisfaction with long term goals. Self-control bias may cause investors to save too little in their early years while, in an attempt to compensate, assume too much risk in later years by holding inappropriate investments for example . To mitigate, investors can stick to a budget and create their own investment philosophy they abide by.

Endowment Bias: The idea that what an investor currently has is better than what they could have. The classic example would be making decisions based on sentimental value.  Endowment bias could lead clients to hold a less than optimal asset allocation such as an inheritance. A factual analysis needs to be done in this scenario. In the case of inherited investments, people could consider how they might have invested the value of their inheritance, had they received it in cash. With an absence of sentiment, a client’s investment decisions are often very different.

Loss Aversion Bias: The most prevalent bias, the strong preference for avoiding losses over enjoying similar gains. For example a person is given a choice between losing $100 or forgoing a gain of $100, investors with this bias almost always choose the latter, even though the loss is the same in either scenario. This bias could lead investors to sell winners prematurely, which may reduce upside potential, and hold losers for too long, which may increase risk. To mitigate, investors should objectively forecast their risk and expected return. 

Regret Aversion Bias: People with this bias are afraid of the humiliation and regret they may feel if they make an incorrect decision, which leads them to avoid making any move at all. Implications include portfolios that are too conservative or too aggressive. Investors can mitigate by educating themselves on what is reasonable risk and expected return. Keeping long-term objectives in mind and knowing that downturns are inevitable will help people get over their fear of making the wrong move.

Overconfidence Bias: The tendency to overestimate your own abilities, knowledge and access to information. Overconfident investors believe they are much better at investing than their record would indicate. Portfolio implications include: underestimation of risks; lack of diversification; excessive trading; attributing gains to your own abilities and blaming losses on the state of the market. Clients should carefully consider the reasoning behind their investments and try to be as objective as possible when estimating risks and returns. But none of that applies to you right?

Status Quo Bias: The feeling of being uncomfortable with change. People with this bias often miss opportunities to rebalance their portfolio to better fit the changing environment. This is a difficult bias to overcome, but investors can try to mitigate through education and quantifying the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.

Cognitive Biases

Hindsight Bias: This is the tendency to believe that events of the past could easily have been predicted. This may lead to a false sense of confidence that tempts the investor to take on excess risk and make bolder predictions in the future. To mitigate, education is crucial. It’s important for the investor to keep and review records in order to determine successes and failures, and to avoid associating success with the possession of special insight.

Representativeness Bias: The choice to make blanket generalizations without properly calculating the probability of the generalization. This also refers to the belief that a small sample is a good representation of the entire population. People with this bias may put too much weight in small data sets with short time periods, and they may overreact when presented with new information. To overcome this bias, investors can educate themselves to understand the basic principles of statistical analysis and develop a suitable long-term strategic asset allocation.

Anchoring Bias: This occurs when investors set expectations to a certain quantity or number, like percentage returns,, then adjust that anchor incrementally as new information comes in. Investors who hold on to a number may not be able to adjust quickly enough to adapt to major changes. To mitigate, investors should consider what would happen if a new analysis were made given current circumstances, instead of starting from the initial anchor point. One should remember that past prices, market levels and reputation provide little information about an investment’s future potential and thus should have little consideration on buy and sell decisions.

Confirmation Bias: This is the tendency to seek information that supports your predetermined assumption, while ignoring or undervaluing information that contradicts that view. This bias can lead the investor to heavily concentrate in particular sectors or geographies, while ignoring diversification opportunities. To overcome this bias, investors should seek out contrary information and alternate methods of analysis. Making the effort to gather more information, pro and con, will likely result in better decisions.

Illusion-of-control Bias: Individuals with this bias incorrectly assume they can influence the outcome of certain investment asset. Implications include excessive trading and concentrated positions in securities that the investor believes can be controlled. To mitigate, investors need to understand the complexity of global markets, where even powerful investors have little control over their investments.

Conservatism Bias: When investors are slow or unable to change their belief despite changing information coming to light. Individuals with this bias may not react fast enough to dynamic circumstances and may hold investments for too long. To help overcome this bias investors may need to seek out new information and alternative views.

Framing Bias: This happens when people are influenced by the manner in which the information is presented. Framing bias could lead the client to lose sight of the big picture by focusing on specific aspects of the information. To assist with this bias, investors should focus on expected return and risk and try to be neutral and open-minded when interpreting investment-related situations.

Availability Bias: The habit of overestimating the probability of an event based on how easily such an event can be remembered. Easily recalled events are often perceived to be more likely than those that are harder to recall or understand. This could lead to missed opportunities, and the failure to achieve appropriate diversification. Investors should take the focus off recent and easily recalled financial events by adhering to a disciplined research process sticking to their own investment philosophy.

Mental Accounting Bias: People with this bias will treat money differently depending on irrelevant classifications such as the source of the money (e.g., salary, bonus, inheritance, gambling) or the planned use of the money (e.g., leisure, necessities). The view of a portfolio in compartmentalized components, as opposed to a whole, incorrectly shifts emphasis off aggregate return while placing unnecessary focus on the performance of individual parts. To mitigate, investors should try to try to keep the focus on total return and overall risk, and create a portfolio strategy that take all assets into account.