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Twelve investment biases

This article is about investment biases in general, not Orbis Access in particular.

Investment biases

Head or heart?

Ideally, investing would be an entirely rational pursuit and free of emotion. But we humans are far from Vulcan in nature when it comes to finance. Our biases can get in the way of effective investing (and plenty of other things).

Biases seem to have become hard-wired into the human brain as our decision-making processes evolved. While they may cloud our judgement, biases aren’t simply flaws. Nor do they necessarily cause us to make the wrong decision. They just affect the type of decisions we do make.

No one can escape such biases entirely, but anyone who can control them – or at least have greater awareness of them – is at an advantage when investing.

At least in theory, professional investors should have learnt to cope with such biases better, but they’re far from immune. Some of the best investors in the world readily acknowledge their ongoing struggle to suppress them.

While we are prone to all sorts of biases, they aren’t always clearly defined and there can be crossover between different types. The list below is not comprehensive - just a quick taste of some common biases that affect us all (in no particular order).

As you can see, it’s easy to exaggerate our own abilities or be otherwise tempted to make less-than-ideal decisions.

Bias

What is it?

In practice

Loss aversion It seems we humans prefer avoiding financial losses about twice as much as we do seeking equivalent gains. 

It’s very tempting to hold on to bad investments – and potentially pile on additional risk -rather than accepting a loss by selling bad investments.

Come to terms with ‘mistakes’ and move on.

Present bias

Is a bird in the hand always worth two in the bush?

We humans are into instant gratification and overvalue things we are able to get our hands on right now, compared to stuff that pays off in future. 

An ability to withhold pleasure now for pleasure in future is an advantage when investing.

Many young people don’t invest in a pension (despite big benefits starting young, due to compounding) because the rewards are too far into the future.
Mental accounting

We sometimes treat money differently, depending on where it came from or what it’s intended to be used for.

You may be willing to buy a £5 coffee on holiday because it’s part of the ‘holiday budget’. But you wouldn’t dream of doing the same at home.

It’s not uncommon for people with store/credit card debt (attracting high interest) to also have money sitting in cash saving accounts (attracting less interest). Usually it makes sense to use the savings to pay off the debt.

Try to treat all your money the same.

Over-induction

You probably haven’t heard of it, but if you ever saw a cloud that looked like Elvis, you’ve done it! Pareidolia is when our brains find ‘meaning’ in random patterns.

In similar vein, give us humans a small set of data and we are likely to infer more from it than we should.  Put another way:  2,4,6….does not always mean that 8 comes next, but we assume it does.

To make matters worse, we put particular weight on the most recent numbers in a sequence. 

Be aware that ‘evidence’ you see in data, especially forecasts, could be wishful thinking. A recent uptick in share price doesn’t necessarily mean it’s a long term trend!

Avoid over-emphasising recent events and concentrate more on the long-term.

Framing & Anchoring

How you ask the question, affects the results you get.

Ask a bunch of people if the middle-aged person in a photo is over 40 and then take a shot at guessing their exact age. Then ask a second batch whether the person in the picture is ‘over 50’. The second set of guesses will be older, on average.

Anchoring is where estimates we make are influenced by other recently-encountered numbers. They don’t even have to be related!

An old marketing trick. Is that £5 bottle of wine on ‘half price’ offer worth £10? Or is the supermarket ‘framing’ the price at £10, independently of its actual worth?

Just because an investment is now lower in price, it doesn’t necessarily mean it was ever worth the higher amount.

Don’t fixate on arbitrary numbers, such as a share ‘breaking the £10 barrier’.

Overconfidence

About 80% of us rate ourselves as being ‘above average’ drivers, even though of course only 50% of us actually are. The same goes for plenty of other activities.

While we tend to be over-confident in estimating our ability to perform easy tasks, we can also be under-confident when it comes to hard tasks.

We are inclined to overestimate investment returns and underestimate the possibility of negative results.

Your ability to predict the future is unlikely to be as good as you think!

Ambiguity aversion  People are less keen on playing games where they don’t know what the odds of winning are in advance.

It’s tempting to opt for an investment with known (or guaranteed minimum) future rate of return, over one where future returns aren’t known in advance.

That applies even if the (historical) chances are that the latter will turn out better. Some financial products actively exploit this bias.

Confirmation

We look out for sources of information that fit our view of the world and tend to ignore those that challenge it.

Conspiracy theorists get particularly caught up in this bias.

If you think the market is about to go up, you will find plenty of people online ‘confirming’ your view. If you think the market is about to go down, you will find plenty of people ‘confirming’ that too. They can’t all be right!

Be open to alternative views.

Sunk cost fallacy

Otherwise known as the tendency to ‘throw good money after bad’. Related to loss aversion.

As in: “we must keep attacking this hill because so many soldiers have died trying to take it.”

Try not to let past losses influence your current decisions when investing. 
Rules of thumb When choosing from a menu of options, we are likely to employ various mental ‘shortcuts’ to make a decision. These include a tendency to stick with familiar items, prominent items, avoid complex choices and more. The technical term for this is heuristics. While rules of thumb can be helpful when forced to make quick decisions, that doesn’t necessarily mean they generate the best decisions.
Home country Investors tend to favour their home markets (regardless of merit). British investors allocate half their shares with UK-listed companies, even though the UK stockmarket accounts for less than 10% of the global total. (source: Vanguard)
Gamblers fallacy “I just threw five heads in a row, so I must be ‘due’ tails next.” Wrong! The chances are of course 50-50, just as before. Even goalkeepers fall for it! Don’t necessarily expect future investment returns to ‘balance out’ recent performance (around some historic average). Probabilities don’t have memories.

Related links

  • An A to Z of Behavioural Bias

    A list of common biases with brief descriptions, examples, causes, ideas for dealing with them and suggested further reading.

    The Psy-Fi Blog

  • The bias curse

    “In his erudite history of financial speculation, Bob Swarup lists a whole set of behavioural biases to which we are all prey.”

    The Economist (Buttonwood blog)