Do Emotional Biases Play a Role in Investment Decisions?
Biases can be attributed to two main categories: emotional biases and cognitive biases. Emotional biases are those that arise spontaneously as a result of attitudes and feelings causing the decision to deviate from the rationale of traditional finance. On the other hand, cognitive biases are basic statistical, information processing, or memory errors that cause the decision to deviate from rationality.
The cognitive biases can then be further broken down into two sub-categories, including:
1) existing belief biases and 2) information processing biases.
Although there are many biases under each of these categories, in the next few paragraphs, we will focus on the most common biases that are frequently manifested in making investment decisions, and will illustrate each bias with a few examples to help investors recognize, and hopefully avoid, such biases.
Let’s first discuss emotional biases.
A. Emotional Biases:
Arise spontaneously as a result of attitudes and feelings that can cause the decision to deviate from the rational decisions of traditional finance. Here are the eight most common emotional biases.
1. Loss aversion: Investors find and feel the idea of losses twice as painful as the pleasure of gains. This asymmetrical risk versus reward outcome is the cornerstone of The Prospect Theory.
- Investors tend to hold onto losing investments for too long. This is often referred to as “get-even-itis” and expose investors to excessive losses.
- Investors sell winners too early, fearing their profit will evaporate. By doing so, investors are limiting their investments upside potential and are likely to engage in excessive trading.
- The most disastrous manifestation of the “loss aversion bias” is that it could lead investors to eliminating the investments and moving to cash (for example, during the 2016 presidential election). This might force investors to incur an inappropriate degree of risk, later in life, in an effort to make up for the lost growth, which could significantly jeopardize the well-being of their overall financial situation.
2. Overconfidence: This occurs when investors have unwarranted faith in their own thoughts and abilities to evaluate, select, and manage investments.
- When investors overestimate their ability to evaluate investments, they become blind to any negative information that could be warning signs and would contradict their assessment. This could lead to underestimating the investment’s downside risk because the investor doesn’t know, doesn’t understand, or doesn’t read investment performance statistics.
- Overconfident investors often don’t even realize they are accepting more risk than they normally tolerate which can lead to holding undiversified portfolios.
3. Self-Control: This is the investors’ tendency to focus on instant gratification, but failing to act in the best interest of long-term goals. This is mainly due to lack of discipline.
- Investors who spend more today at the expense of savings for tomorrow. This might lead to imbalanced asset allocation due to investors favoring income-producing assets due to the “spend today” mentality. Investors may be forced to assume an inappropriate level of risk, later in life, in an effort to make up for the lost time.
- Investors who fail to plan for their retirement are less likely to retire securely than those who do plan. People who do not plan for retirement are less likely to invest in equities.
- Self-Control bias may lead investors to ignore basic financial principals such as rebalancing, compounding, and dollar cost averaging, which when executed appropriately, help create significant wealth to investors.
4. Status Quo: This bias is experienced when investors are faced with an array of options. In such case, they are predisposed to select the option that keeps conditions the same.
- Investors continue to hold certain securities only because they are familiar with or they are emotionally attached to, irrespective of the actual securities’ merit. By taking no action (keeping the status quo), investors may continue to hold investments with inappropriate risk levels (high or low risk) relative to their risk/return profile.
- When the status quo bias is combined with “loss aversion bias”, investors become very reluctant to make any changes despite the higher return that could be achieved by selecting a new investment as an alternative. This is because status quo offers the investor a lower probability of loss fallacy. This could lead investors to assume more risk and potentially achieving suboptimum total returns.
5. Endowment: Occurs when investors assign a greater value to an object they already possess and may lose, than an object of the same value they do not possess, and has the potential to gain.
- Investors might hold onto investments that were owned by previous generations and assign a greater value to particular stock(s) or real estate that may have created the family’s wealth, without justification for why these assets are retained and regardless of its suitability to avoid the appearance of disloyalty to prior generations or to avoid tax consequences. It could also be due to their familiarity with the endowed securities characteristics.
- When investors place irrational premiums on assets they already own, it leads to “decision paralysis” where making a decision to dispose of the asset becomes paralyzed. In such case, investors will likely fall into the “status quo bias”.
6. Regret aversion. This is when investors avoid taking decisive actions because they are afraid that, when looking back at the course they selected, it will prove less than optimal. This bias is not to be taken lightly. According to a 2015 CFA® Institute survey, Herding Mentality, which is one of the manifestations of the Regret Aversion Bias represented over one third of the biases that affect investment decision making.
- Investors who are reluctant to make bold investment decisions because they have suffered losses and felt the pain in the past (aka: Snake Bite effect). This leads investors to be too conservative and to unduly shy away from markets that have recently gone down.
- Investors buying into the apparent mass consensus (aka: “Herding Mentality” Behavior), which can limit the potential for future regret. This could lead investors to choose to invest into only Blue-Chip Companies that are widely and commonly held versus other companies.
- This bias leads investors to cling to and hold both losing investments as well as winning investments for too long failing to “cut losses” or “lock gains” when appropriate.
7. Affinity bias: Apparent in investors who are prone to make decisions based on how they believe a product or service reflects their values or self-image.
- Investors taking positions only in ESG companies or that offer products and services that they like without carefully examining the soundness of the investment characteristics of those companies.
- Investors making investments in “sophisticated” products just to convey a status only without understanding what they own.
8. Home country: Also known as “patriotic investor bias,” where investors have the tendency to be more familiar with, and confident in, companies within their own country and boarders. As a result, they favor those companies with heavy allocation within their portfolios, missing on growth opportunities in other regions and the added diversification benefits derived from a global asset allocation approach.
Next month, we’ll dive into “cognitive biases” and will continue the discussion on 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.
To read the third part in the series, please click here.
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CIMA Text: Investment Advisor Body of Knowledge