Key takeaways
Biases are often unconscious thoughts that can influence decisions. They are present everywhere, including in investing, and may lead to decisions inconsistent with long-term goals.
Common investing biases include:
- Loss aversion — greater focus on avoiding losses than making gains.
- The endowment effect — assigning a higher value to assets that are already owned, regardless of their true market value.
- Herd mentality — following the actions of a larger group rather than performing independent analysis or evaluation.
- Anchoring — relying too heavily on an arbitrary price point or valuation.
- Confirmation bias — interpreting information so as to confirm pre-existing beliefs.
- Underestimation of downside risk — underestimating the potential for negative outcomes or losses.
Being aware of biases is the first step in overcoming them. Establishing investment objectives and sticking to a strategic asset allocation can help to put guardrails in place to aid in evaluating investments objectively and remaining on track to meet investing goals.
Understanding bias
A bias is a tendency to favor or oppose something based only on a partial assessment of its merits. Biases can be either learned or innate and are often unconscious. They are a common occurrence and can affect decisions in many areas, including investing.
Luckily, simply being aware of many biases is the first step to overcoming them and ensuring that decisions are made in alignment with long-term goals.
We explore six common investment biases and the impact that may have on decision making.
The science of behavioral biases
Like all decisions, investment decisions may be influenced by biases relating to how we process information and to feelings.
The academic field of behavioral finance explores these biases, which can encompass mental shortcuts and emotional reactions. They can lead us away from objective financial choices, and as such understanding these inherent human predispositions can aid in making more effective investment decisions.
Common investment biases
Loss aversion
Loss aversion is the tendency for the psychological pain of losses to be felt more intensely than the happiness brought by equivalent gains. This can lead to holding assets that have fallen in value for longer than is optimal — in order to avoid psychologically realizing the loss.
Loss aversion can also result in avoiding investment opportunities that may involve greater perceived risk (and so the potential for loss), impacting portfolios by potentially misaligning asset allocation compared to one that may be better aligned with long term goals.
The endowment effect
The endowment effect is the propensity to assign a higher value to an asset because it is already owned than would be the case were the same asset not owned.
This tendency may result in reluctance to sell an asset at fair market value if the mentally assigned value is higher, even if a new purchase of the asset wouldn’t be made at this higher mental valuation.
The endowment effect can lead to assets being held for longer than is optimal, especially when the price of the asset falls.
Herd mentality
Herd mentality describes following the actions of a larger group, rather than performing independent analysis and evaluation of an investment opportunity and acting accordingly.
Herd mentality can reinforce asset price movements, both up and down. Fear of missing out on a potential investment experiencing price gains can lead to collective buying that may drive prices higher still. Conversely, if an asset is selling off, a feeling of safety in following the actions of others may encourage more sales, resulting in further price declines.
This can lead to buying assets at high prices and selling at low prices and thereby increasing portfolio volatility.
Anchoring
Anchoring describes the tendency of focusing too heavily on an arbitrary data point or valuation. Common examples of such anchor points include the price paid for an asset, a recent high or low price, or an analyst target.
Anchoring on such an arbitrary point may then skew decisions around buying or selling the asset if they are taken in context of the anchor rather than current market value. For example, an asset that has lost value may not be sold because the perceived value is anchored on the purchase price rather than its changed value or outlook.
Confirmation bias
Confirmation bias is the tendency to seek out or interpret information in a way that confirms preexisting beliefs, whilst simultaneously downplaying information that goes against these. This contrasts with an objective assessment that would evaluate all relevant information.
Confirmation bias can prevent an objective assessment of both potential purchases and sales of assets as well as their valuations and outlook. It can lead to overconfidence in views and suboptimal decision making.
Underestimation of downside risk
Underestimation of downside risk describes the tendency to underestimate the potential for negative outcomes or losses from investments.
Underestimating downside risk can lead to too much risk being taken relative to a desired tolerance level, and insufficient employment of beneficial risk-management approaches, such as diversification.
Addressing biases
The first step to mitigating any bias is simply to be aware of it. When it comes to making investment decisions, acknowledging the potential presence of biases can itself help in overcoming them.
Adopting and adhering to a long-term strategic asset allocation with guidelines for rebalancing investments, can help to keep portfolios aligned with goals.
Pre-defined investment objectives and risk tolerances against which potential investment decisions are evaluated, can help to add objectivity to decision making.
The use of professional investment managers may also be useful, reducing the impact of personal biases.