Psych 102 – Investor Biases and how to fix them

This is the second post in a series on Psychology in Investment. Today we’re going to look at some of the investor biases that can affect our behaviour, and hence our returns.

Investor biases and investor behaviour

Investors make decisions based on past events and personal beliefs and preferences. They establish rules of thumb as short cuts to save time or reduce complexity. These heuristics can lead investors away from rational, long-term thinking. Investors can also be swayed by their emotional states.

Psychologists would split behavioural biases into two categories. They distinguish between cognitive biases (the tendency to think in certain ways, to rely on heuristics) and emotional biases (where feelings over-ride facts).

As investors, these distinctions are less useful. We want to identify which biases (if any) are useful – it’s possible to imagine heuristics that improve our return, or at a minimum save time in making decisions and do not significantly harm our returns – and those which which are not. We would then look to retain the former and come up with ways to counteract the latter.

We will now look in turn at the main seven types of biases that investors exhibit.

Representativeness and trend-chasing

People (investors included) have a tendency to see the future as a continuous extension of the present. In investing, this results in recent performance and current economic conditions being given too much weight when predicting what might happen in the future.

Thus people buy stocks when they have risen¹ and sell at the bottom. It’s important to look at the big-picture and the long-term trend. Mean reversion is the norm.

In a closely related bias, investors tend also to see the future as an extension of the immediate past. Fund managers exploit this in the marketing of funds when their recent performance is good. Don’t follow the herd of jump on the bandwagon – think mean reversion.

Loss aversion (regret) and the disposition effect

People prefer to avoid losses more than they like to achieve gains. They fear making decisions which might have bad outcomes, or taking actions which might cause them to regret a decision from the past. As a result they often avoid making any decision or action at all.

In investment, this contributes to risk aversion (we all know people who would rather keep their savings in inflation-eroded cash accounts than in the stock market) and also to the tendency for investors hang on to losing stocks in the misplaced hope they may recover.

The disposition effect is closely related to loss aversion and explains both the reluctance to cut losses and the tendency to sell winners (and “lock in” a profit) too early.

Familiarity bias

People prefer what they know and are comfortable with. Investors have a bias for familiar investments. This starts with cash, and continues in the form of home bias, the tendency for investors to prefer stocks from their own country over international and emerging market stocks.

There is some logic to being overweight in securities from (and in the currency of) the country where you live, but most people take this too far. International diversification is very beneficial in the long-run, and at least 50% of stocks should be outside the home country.

Worry

Worry is a perfectly normal emotion, but in investment it contributes to risk-aversion. The volatility of stocks is given more weighting than their long-term out-performance, and less volatile investments (eg. bonds, cash) are preferred regardless of economic circumstance.

It is important to decide on an asset allocation plan for a portfolio, and stick to it, by rebalancing on a regular schedule.

Anchoring

In general, anchoring is the tendency to hold onto an initial belief and use it as a reference point for future situations. In many technical skills (eg.music, sports) this shows up as the bad habits picked up during early practice. The same is true of investment, but a more specific manifestation is the tendency of investors to attach special significance to numbers (eg. the price at which a stock was purchased) when deciding whether to hold or sell.

Major market events such as the 2008 crash² can cloud judgement in a similar fashion. A significant negative experience can “scar” an investor, leading to increased worry and risk-aversion, and insufficient exposure to stocks.

It’s important to analyse investment decisions by reference to the range of likely future outcomes, and not a single situation from the past.

(Self-)attribution bias

We all like to take credit for things that turn out well, and blame others for those that don’t. This leads to over-confidence, which in turn often leads to over-trading (and hence underperformance).

The market is always right, and if we get an investment wrong, we need to look at what we did for clues on how to be better next time. A trading diary is a useful tool here, as is the feedback of other investors where practical.

We also need to make use of well-constructed benchmarks to judge our performance, rather than simply looking at nominal returns.

Hindsight bias

This works both ways – people like to think that they knew all along about the bubbles that they avoided (probably through laziness / inaction rather than insight) and they also like to talk about the reasons why everyone should have been in on their winners.

Past events are always easier to understand once their outcomes are known. But things can play out in may ways, not all of which will be obvious at the time. We need to be clear about why we did what we did, when we did. A trading journal or log will be very helpful here.

Two types of investor

Baker and Ricciardi describe two kinds of investor:

1. overconfident (and hence over-active):
   • most people are overconfident, and especially men, who make up the vast majority of investors
   • less confident women trade less, using buy-and-hold more frequently
2. status quo (too passive and inattentive):
   • these investors stick to their existing positions no matter what the economic conditions
   • the majority of pension holders make no trades over a two-year period
   • they are also prone to defer making pension contributions at all

The goal is to find a balance between the two positions:

• using a trading journal and benchmarks can reduce the tendency to attribute success to superior knowledge and skills
• using a lifetime plan for retirement with regular reviews and rebalancing to a declared asset allocation can overcome inertia

Lessons for investors

1. Look at the big picture (the long-term trend).
   Remember mean reversion. Don’t buy high, sell low.
2. Make a lifetime investment plan (money targets, asset allocation appropriate to your risk tolerance) and stick to it.
3. Invest internationally for diversification.
4. Analyse investment decisions according to the likely future outcomes, and not a single situation or number from the past
5. Cut your losses and let your winners run.
6. Have regular reviews and rebalance as needed.
7. Keep a trading diary and be honest about your successes and failures.
8. Compare your returns to a sensible benchmark
   – don’t simply look at nominal returns

Sources

1. Make sure you don’t hold these 3 biases – 5i Research Blog

2. How Biases Affect Investor Behaviour – Baker & Ricciardi, European Financial Review

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1. though this can be good in the short-term – see the momentum effect [↩]
2. or for older readers, the 2000 and 1987 crashes [↩]