It is a curious fact of life that many of the instincts and reflexes that have helped human beings survive and evolve over tens of thousands of years can actively – albeit subconsciously – work against us when it comes to investing.
To pick just one example, the ‘herd instinct’ that served to keep us out of the jaws of sabre-toothed predators all those years ago tends to be a recipe for disaster in the context of the stockmarket today.
These instincts – or ‘heuristics’, to give them their technical name – are mental short cuts developed over many millennia where intellectual rigour has been sacrificed for the sake of reaching a speedier decision.
They are, in effect, hardwired into the human brain – part of how we have evolved and of what we are – and thus, rather than hope to change them, we must do our best to learn to work with them.
As a result, behavioural science – and its financial offshoot, behavioural economics – have over the years proved fertile ground for articles, here on The Value Perspective. So we thought it would be useful to corral the key behavioural biases investors need to be alert against into one handy checklist – albeit one handy checklist divided neatly into two halves.
That is because investors’ inherent biases can roughly be split into two types – ‘cognitive errors’ and ‘emotional biases’.
The latter are more difficult to address than cognitive errors, which we deal with here, because they stem not from conscious thought but a mix of gut feelings or intuition and human impulses. As such, rather than the actual process used to analyse data, they effect the framing of information and decisions.
* Loss-aversion bias: Investors feel the pain of a loss much more acutely than they feel the pleasure from an equal gain. This sort of myopic loss aversion can be seen time and again in markets where a short-term risk factor means investors start pricing in an excessively high equity risk premium.
* Overconfidence bias: Quite simply, investors start to overestimate their own ability in the belief their intuition and reasoning are better than they actually are. This could be down to an illusion of knowledge or a ‘self-attribution bias’, which is where an investor take personal credit when an investment comes good – yet any investment that goes bad is somebody else’s fault.
* Self-control bias: As anyone who has ever hit the ‘snooze’ button on their alarm will appreciate, we can all lack self-discipline at times – favouring instant gratification over playing the long game to achieve our goals. This bias can lead investors to take on too much risk at a later date as they attempt to make up any shortfall that has resulted. To continue our analogy, it is akin to speeding to an appointment in order to claw back those extra minutes spent dozing before the alarm went off a second time.
* Endowment bias: Investors can often overvalue stocks they already hold in their portfolios – apparently thinking that alone endows them with some special quality. It doesn’t.
* Regret aversion bias: Investors will often prefer to do something when inaction would have been the better course but this is an exception: investors doing nothing if they fear that, by doing something, they could make a mistake. This can lead them to overweight ‘actions of commission’ (doing something when they should have done nothing) while underweighting ‘actions of omission’ (doing nothing when they should have done something). A good example is the ‘herd instinct’ mentioned earlier, which makes it easier to follow a crowd of other investors rather than do something different alone for fear it turns out wrong and you look silly.
* Status quo bias: Investors overweight recent information and take comfort in the existing situation and forecasts, leading them to be unwilling to make changes.
One final point worth noting here is that it is not just individuals who can be afflicted by these behavioural sins of cognitive errors and emotional biases – teams and committees can be too.
In other words, when individuals come together in groups, the combination of their personal biases will affect the resulting investment decisions.
Groups also have a significant susceptibility to ‘social proof bias’.
This is where members of a group – whether because they are more junior, less outspoken or less confident – can feel reluctant to voice their opinions and instead go along with the views of their more senior, louder or more confident colleagues to avoid causing offence.
This can be mitigated by operating a more open approach to challenge and respecting others in the team – as well as seeking members with more diverse backgrounds or mind-sets, who are not afraid to express their opinions.