How Biases Can Impact Investors’ Financial Well-Being and Significantly Alter Accumulated Wealth, Part III (a continuation of the four-part series)
Over the last two parts, we’ve discussed how biases impact our decision-making, particularly when it comes to our investments. Continuing to understand our biases can help us better understand why we make our financial, wealth, and investment decisions. As a continuation of our series, we’ll discuss the first type of the Cognitive Biases; the Existing Belief Bias; and provide some illustrating examples.
A. Existing Belief Biases:
The following six biases arise from the individual’s beliefs, judgments, or preferences. .
1. COGNITIVE DISSONANCE: Confusion or frustration that arises when individuals receive new information that contradict and does not match up with or conform to pre-existing beliefs or experiences.
- Investor holding on losing positions to avoid the mental pain associated with the admission they have made a bad decision.
- Investor continue investing in securities already owned after they have gone down in value (averaging down) to confirm an earlier decision, without judging the new investment with objectivity, aka: “Throwing good money after bad”.
- Investor can get caught up in herds when they receive so much information that is counter to their beliefs and start behaving in a Herd Mentality.
2. CONSERVATISM: Takes place when people cling to their prior views or forecasts at the expense of acknowledging new information. This is because individuals are typically slow to change their views and forecasts that they have formed over a period of time. Also conservatism can be found when people are experiencing mental stress because they were presented with complex data that are difficult to interpret, in which case, it is easier for them to stick with their prior belief.
- Investor clinging to initial optimism and failing to take action with a position he/she owns of a company that had promised a new product even after the company declared that it had experienced problems bringing the product to the market.
- Investor is too slow to sell a stock after unfavorable earning announcement due to his view of the company’s good prospective. He may linger too long causing him to sell it at much higher loss.
- Investor failing to change his prior view of a company after it announces new accounting procedures (that are difficult-to-interpret by the investor) that may affect its growth.
3. CONFIRMATION: Occurs when investors observe, overvalue and/or actively seek out information that confirms/supports what they believe while ignoring and/or devaluing information that contradicts the same beliefs.
- Investor who strongly believe in predetermined “Screens” such as 52 week high. They may blind themselves because a stock breaking a 52 week high might not be a good investment.
- Confirmation Bias may cause employee to over-concentrate their investment in own company stocks, caused by the intra-office buzz regarding the company’s great prospective, ignoring the risk mitigation benefits of diversification.
4. REPRESENTATIVENESS: When investors process new information using pre-existing idea or beliefs or when they view a particular situation or information in a certain way because of similarities to other examples even if it does not really fit into that category.
- Investor who examine money manager’s track record for the past few quarters or even years and conclude, based on inadequate statistical data, that the fund’s performance is the result of skilled allocation and/or security selection. Similarly, investor assessing a stock analyst’s aptitude by investigating his/her past few recommendations, would erroneously arrive to the wrong conclusion due to the limited data sample.
- Investor classifying an AAA rated Municipal Bond issued by an “inner city” and racially divided county as a high risk bond. In this case, the Bond characteristics may cast a shadow of high risk because of the county’s “unsafe” reputation. However, this conclusion ignores the fact that, historically, the default rate of AAA bonds is extremely negligible and virtually zero.
5. ILLUSION OF CONTROL: Investors believe that they can control or influence investments outcomes, when in reality, they cannot!
- Investor maintaining under-diversified portfolios and hold concentrated positions because they gravitate towards companies with a fate they feel they have some amount of control.
- Investor using limit orders and other techniques in order to experience a false sense of control over their investments. The use of these mechanisms can cause the investor to overlook opportunities or, even worse, unnecessary purchase based on the occurrence of arbitrary price, which is very detrimental.
- Illusion of control contributes to Overconfidence Bias (discussed later). This is common with a successful business owner who believes that he/she would be successful in investment, just because, they have been successful in their business.
6. HINDSIGHT: Investors perceive investment outcomes as if they were predictable, even if they were not. Hindsight bias gives investors a false sense of security when making investment decisions, leading them to take excessive risk.
- Investors who believe that they have superior predictive powers after their investment appreciate can lead to excessive risk-taking (the Tech bubble in the late 90’s is an example of this bias). Are we experiencing a 2.0?!
- When investment poorly performs, investors tend to “Rewrite History” by blocking out the recollection of prior incorrect forecasts to avoid embarrassment. Self-deception, is a cognitive dissonance that prevent investors from learning from their mistakes.
- Investors who perceive that every development in the market is inevitable, so when their investments underperform, they unjustifiably fault their money manager, surprised by how the manager was caught by surprise! The reality is; even top manager experience periods of underperform due to having a style that, just temporarily, out of favor (Value stocks are a current example of a style that might be currently out of favor). Conversely, investor who unduly praise his/her money manager, when experiencing good performance, which could be due to only good timing or good luck.
Next month, we will conclude our Behavioral Finance series by discussing the second type of Cognitive Biases; the Information Processing Bias; and how different investors can manifest multiple biases depending on their various financial stages in life.
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