Behavioral bias in investment decision making

Cognitive bias in investment decision-making

We’ve compiled a list of the main unconscious biases and their influence on the way we invest and make financial decisions.

To understand the presence and impact of cognitive bias in active investment management, download our free white paper by investment process expert, Eric Rovick. It offers practical steps for portfolio managers who want to recognise and manage bias in their daily investment process.

Anchoring

When we rely too much on the first piece of information we came across when making a decision.

Availability Heuristic (aka Availability Bias)

A mental shortcut by which one overestimates the importance or likelihood of something based on how easily an example or instance comes to mind.

This bias is important because of its impact on how well we perceive risk. Of course, what we remember or how easily something comes to mind will be influenced by many things but media coverage is usually a big factor.

Daniel Kahneman “People tend to assess the relative importance of issues by the ease with which they are retrieved from memory—and this is largely determined by the extent of coverage in the media. Frequently mentioned topics populate the mind even as others slip away from awareness…”.

Daniel Kahneman – Thinking, Fast and Slow (2011)

Bandwagon Effect

Believing something is true or correct because many other people do.

Blind Spot Bias

Demonstrated when we think we’re less prone to cognitive bias than those around us.

Emily Pronin“People see themselves differently from how they see others. They are immersed in their own sensations, emotions, and cognitions at the same time that their experience of others is dominated by what can be observed externally.”

Emily Pronin – How We See Ourselves and How We See Others (2008)
Photo source: Department of Psychology, Princeton University

Conjunction Fallacy

This representativeness heuristic is a tendency to assume that specific conditions are more probable than general ones.

Clustering Illusion

The tendency to overestimate the importance of small patterns or clusters found in a large amount of data.

Confirmation Bias

Also called confirmatory bias or myside bias, this is the tendency to search for, interpret, and remember information in a way that confirms their existing preconceptions. This unconscious bias makes it possible to miss findings or ignore evidence that could otherwise change our view.

“Now, there was a smart man, who did just about the hardest thing in the world to do. Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man’s natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience–a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.”

Warren Buffet in Fortune Magazine (2001)

Conservatism Bias

When we cling to an initial viewpoint even when there’s new information or evidence that challenges it.

The Curse of Knowledge

When knowledge of a topic diminishes our ability to think about it from a less-informed, but more neutral, perspective.

Disposition Effect

An expression of loss Aversion, the disposition effect was identified and named by Hersh Shefrin and Meir Statman in 1985. It is the tendency common to both professional and amateur investors to hold on to losing investment positions for too long, whilst selling winners too soon.

Research into the investment impact of the disposition effect by Terrance Odean (Are Investors Reluctant to Realize Their Losses? – 1998) showed that winners that were sold outperformed losers that were retained by an average excess return of 3.4% per annum.

“Meir Statman and I… coined the term disposition effect as shorthand for the predisposition toward get-evenitis.”

Hersh Shefrin (2000)

Endowment Effect

When we consider an asset that we already own as more valuable than similar assets that we don’t. Also known as the divestiture aversion.

The term was coined in 1980 by Richard Thaler who was the first person to systematically study the bias.

One of the most famous experiments into the endowment effect is the 1990 research carried out by  by Daniel Kahneman, Jack Knetsch and Richard Thaler. In this study, some of the participants were each given a mug. They were not told the retail price of the mug and were each asked to list the lowest price they’d be willing to sell it for. Other participants didn’t receive a mug and were asked how much they’d be willing to pay to buy one.

The difference in price from each group for the same mug was striking: those with the mug listed selling prices that were too high for the buyers (on average, they would not sell for less than $5.25). In contrast, those buying the mug did not want to pay more than $2.25 – $2.75.

This experiment was repeated with other objects, including pens. Even when the price tag was left on the pen, the same effect was demonstrated – with pen sellers listing sale prices of $4.25-$4.75, even when the pen’s price tag showed $3.98.

Watch: A nice explanation of the endowment effect and how it relates to loss aversion

The Framing Effect

Drawing different conclusions from the same information, depending on how or by whom that information is presented.

Gambler’s Fallacy

The belief that future probabilities are altered by past events. This bias is a product of “representativeness”, a psychological phenomenon that leads us to rely overly on heuristics (rules of thumb) or “stereotypical thinking” when making decisions or judgements.

Linked to the hot-hand fallacy in basketball, where observers predict a player will continue to play well because recent performance has been so good:

Hersh Shefrin“….statistically, there is no such thing as a hot hand. This is not to say that we do not see streaks. We do see them, but the point is that they have no predictive power! The idea that streaks have predictive power is an illusion. The fact is, as a species, humans have very poor intuition about random processes, whether the process is coin tossing or whether it is three-point attempts in basketball. In particular, representativeness leads us to extrapolate recent performance.”

Hersh Shefrin et al – Behavioral Finance: Biases, Mean–Variance Returns, and Risk Premiums (2007)

Gratification Bias

The tendency to favor short-term gain over greater gain available in the long-term.

Herding Effect

The tendency to follow the actions of a larger group.

Howard Marks - Oaktree Capital“Herd followers have a high probability of achieving average performance, but in exchange for safety from being much below average, they surrender their chance of being much above average.”

Howard Marks, CFA, Oaktree Capital Management (2006)

House Money Effect

The tendency to take on greater risks when investing with profits. The name is derived from the casino-related expression “playing with the house’s money”.

The effect was identified by Richard Thaler and Eric Johnson in their 1990 paper, Gambling With the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice.

The mental accounting of this bias suggests that a successful outcome in a recent trade or investment with above-average risk then leads to a temporary reduction in the investor’s risk tolerance. As a result, the investor seeks even more risk with their next trade.

“How is risk-taking affected by prior gains and losses? While normative theory implores decision makers to only consider incremental outcomes, real decision makers are influenced by prior outcomes”.

Thaler and Johnson (1990)

The IKEA Effect

This bias explains the tendency for people to place a disproportionately high value on objects that they partially created themselves, regardless of the quality of the end result.

In the original 2011 research, The IKEA effect: When labor leads to love, consumers assembled IKEA boxes, folded origami, and built Lego sets. Participants of the study saw their amateurish creations as similar in value to those created by experts and expected others to have the same view. The IKEA effect was only evident when the participants had successfully completed their assembly task; when they built and then destroyed their creations, or failed to complete it, the cognitive bias dissipated.

“The overvaluation that occurs as a result of the IKEA effect has implications for organizations more broadly, as a contributor to two key organizational pitfalls: sunk cost effects (Arkes and Blumer 1985; Staw 1981), which can cause managers to continue to devote resources to failing projects in which they have previously invested (Biyalogorsky, Boulding, and Staelin 2006), and the “not invented here” syndrome, in which managers refuse to use perfectly good ideas developed elsewhere in favor of their – sometimes inferior – internally-developed ideas.”

Norton, Mochon and Ariely (2011)

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