Merriam-Webster Definition of Bias: “An inclination of temperament or outlook”
Synonyms: “Prejudice, bent, tendency”
Effective investors know how to develop a strategy, analyze securities, and make consistent decisions
while keeping a critical eye. However, investing is much more than buying and selling securities
based on business and performance analysis. As humans, we are each subject to a unique array of
mental and emotional biases. Whether it is from parents, friends, or our own deductions, everybody
develops bias in some way during their life. As an investor, identifying and understanding your own
biases can be mentally freeing and preventative of unnecessary loss. While it is impossible to
eliminate bias entirely, it is possible to diminish its influence. The following biases are common
behavioral traits seen in investors. By understanding each, we hope to empower you, the investor, to
identify your own bias(es) and provide you with ways to approach mitigation.
1. Representativeness
Bias: Categorizing the quality of an investment based on recent performance.
Example: “Researchers on behavioral finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year” [Parker, 2021].
Balance: Having a clearly defined & evidence-driven process for evaluating investments may help reinforce long view investing vs. chasing near-term results.
2. Regret (Loss) Aversion
Bias: Many investors go to great lengths to avoid the feeling of regret.
Example: Conducting a trade for an equity with (misplaced) certainty. Even if it slowly declines and shows consistent negatives, many will refuse to sell to avoid regret of being wrong and/or missing an upswing in price.
Balance: Identifying your “growth needs” provides a benchmark on the amount of risk you need to take to reach your goals. Losing investments are inevitable and attempts to avoid them at all costs will most likely lead to inferior long run returns.
3. Disposition Effect
Bias: Sell winning stocks too soon and hold losing stocks for too long.
Example: When selling a stock that has depreciated in value, that money is not entirely gone. Tax-loss harvesting allows an investor to “write off” capital gains tax with capital losses from selling a losing security. Falling for the Disposition Effect will likely lead to disproportionately high capital gains tax and thus negatively affect the long run tax efficiency of your portfolio.
Balance: Following the balance to Representativeness, having a defined process allows for structure on how long to hold securities and when to sell.
4. Familiarity Bias
Bias: Preference for familiar investments, often local or domestic companies. Also evident with individuals who concentrate on investments solely in their occupational space.
Example: The Texas oil man who buys nothing but energy stocks or the millennial tech investor whose stocks consist exclusively of technology names.
Balance: Investing in what you know can be a powerful tool but can be detrimental to your portfolio if it leads to too much concentration and lack of attention paid to valuations. Expand your knowledge of foreign securities and cast a wide net of diversification by industry to avoid this trap. Consider a “core & explore” strategy where the bulk of your funds are in diversified vehicles, and you limit your targeted investments to only a small fraction of your overall portfolio’s size (usually 5-15% of total).
5. Worry
Bias: This mental state of an investor can cause many complications in the success of their investments. Worry and anxiety often increase the perceived risk of investments and cause investors to steer toward more conservative portfolios than necessary particularly in light of their risk capacity.
Example: The investor who is pre-occupied with stocks being at new all-time highs who talks him/herself out of investing for years if not decades at a time. This individual may not realize that stocks are frequently hitting new highs and this form of market timing has never been a reliable way of investing in the stock market for superior returns.
Balance: There are many tests available that can identify your risk tolerance. Unlike risk capacity, which targets how much risk you can afford to take, the purpose of this test is to identify your emotional comfort with risk. A trusted third party investment advisor can help you explore counterarguments to your objections to participating in the stock market. They can also help you balance the importance of your risk tolerance with measures of your cash-flow based risk capacity and growth levels needed to achieve your financial goals.
6. Anchoring (Experience based)
Bias: The tendency to hold onto a belief and using it as a reference to influence future decisions.
Example (#1) : To illustrate negative anchoring, many baby boomer investors emphasize the ’07-‘09 financial crises as their main point of reference, causing them to make excessively risk-averse decisions with their investments.
Example (#2): For an example of positive anchoring, we need only look to the recent recovery from a 35% drop ending in March’20 which has resulted in many peoples’ overconfidence in the stock market’s tendency to “rapidly bounce back”.
Balance: A study of the length of S&P 500 recoveries and a review of a 60-year chart of the Japanese Nikkei 225 may generate a healthy concern for insufficient liquidity and over-indulgence to stock market risk. The Nikkei 225 has yet to recover its 1989 highs. Very few investors find success based on a single point of reference (since insider trading was made illegal). If there have been negative experiences that affect your investor psyche, work to expand your understanding on diversification instead of falling trap to Regret Aversion. Conversely, if you have found great success in your portfolio in this current cycle, you may be vulnerable to Self-Attribution Bias (see below).
7. Self-Attribution Bias
Bias: When someone thinks that the success they have in choosing investments is because of their own personal talent/intellect and disregards the role of luck in building their newfound wealth.
Example: Tesla is one of the most widely covered stocks on the planet (and thus arguably very efficiently priced). In 2020, some investors have made 300, 400, if not 500% on their money invested in TSLA. The inclination might be that some who have achieved these far above average returns have an outsized appreciation for their own investing prowess vs. market dynamics out of their control or understanding (or just luck). This could result in them being overconfident (and thus too aggressive) on additional investments made in the future.
Balance: Humility in investing is a great protection mechanism against devastating stock market losses. It may be worthwhile to look at years when even the greatest investors of all-time have drastically missed the bullseye with their investment strategies. For instance, Buffet’s BRK/B only returned ~2% in 2020 while Ray Dalio’s flagship hedge fund dealt with sizable negative returns for the same calendar year.
8. Herd Mentality
Bias: Making purchases or strategizing based on where the “herd” is going.
Example: Initiated by a Reddit post, a GameStop Corp. (GME) buying craze sent its price from $17.25 to $347.51 between January 4th-27th, 2021. Less than one month later, the price fell back to $40.59.
Balance: Timing a shift in herd mentality is incredibly difficult. In reviewing active mutual fund manager performance track records, an investor can build an appreciation for this difficulty and hopefully avoid getting wrapped up in the influence of the herd.
9. Great Fool’s Theory (Bias)
Bias: When an investor purchases a security, knowing it is overpriced, but believe others (the greater fools) will continue to buy at even more expensive levels thus justifying the overpriced entry point.
Example: Since 2019, many Large Company Growth stocks, primarily in the technology sector, have had >30% yearly returns. Many of these firms trade at valuation levels (like price-to-book value) from which investors have rarely, if ever, enjoyed attractive forward returns.
Balance: This type of approach ignores most quantitative and qualitative measures in pricing a security. It is one thing to buy speculative stocks with 1% of a portfolio but concentrating the entire equity allocation of a portfolio in positions trading at prices which are historically unprecedented may be a reckless strategy for long-term success.
Why This Matters: For those of you that have an Investment Advisor, you may have taken a “Risk Tolerance Questionnaire” to get a benchmark of your willingness to take risk in the stock market.
Although evaluation of this questionnaire plays an important role, it should be weighed against other factors such as “Risk Capacity”, “Risk Needs”, and “Risk Tolerance Assessment timing” when building a financial plan. Regarding the last point, we have observed that clients’ responses to risk assessments vary significantly depending on the climate of the market in which the investor answers the questionnaire. For instance, during the calm of 2017, investors tended to be more risk tolerant per our assessments while we saw a spike in risk aversion in early 2020 amidst the fastest 30% drop in the S&P 500’s history. Taking a multi-faceted approach in determining the appropriate level of risk taking in your portfolio is the best way to build an investment mix that aligns your risk tolerance, risk capacity, & need for growth to meet financial goals. A thorough discussion on potential investment biases (like those above) may further support sound investor behavior during this process.
A key role of any coach is to keep you sane and in check as you practice – be it in a sport
or while investing. The best advisors should help you avoid letting your own mental
biases take over otherwise rational and calculated investment decisions.
There are many other biases that exist including by not limited to those below. Have a healthy level
of appreciation for our susceptibility to fall victim to any one of them!
Confirmation Bias
Availability Bias
Disposition Effect
Overconfidence Bias
Dunning-Kruger Effect
Prospect Theory
Hindsight Bias
Sources:
https://www.investopedia.com/articles/investing/050813/4-behavioral-biases-and-how-avoid-them.asp
https://www.investopedia.com/terms/g/greaterfooltheory.asp
https://www.researchgate.net/publication/280087380_How_Biases_Affect_Investor_Behaviour
https://www.morningstar.com/search?query=nikkei
