What Are Biases and Why Are They Relevant?

Behavioral science tells us that when it comes to making decisions, we're much less rational than we think.

There are a host of cognitive and emotional biases that influence our behavior, which can lead to less-than-ideal outcomes, especially when it comes to investing.

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Cognitive Biases

A cognitive bias is a type of thinking that occurs when we're processing and interpreting information. Think of them as rules of thumb, or mental short-cuts, that help us make sense of the world and reach decisions quickly.

Addressing Cognitive Biases

Knowledge and information can help investors recognize their cognitive biases, but overcoming these biases is best served by helping investors form new habits to change their way of thinking.

WHAT THE BEHAVIORAL SCIENCE EXPERTS SAY

"To err is human. One Way for humans to make better decisions is to become alert to the most common errors."

- Richard H. Thaler

Richard H. Thaler

Nobel Laureate and Charles R. Walgreen
Distinguished Service Professor of Behavioral
Science and Economics
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Richard H. Thaler

Richard H. Thaler is the 2017 recipient of the Nobel Memorial Prize in Economic Sciences for this contributions to behavioral economics. Thaler studies behavioral economics and finance as well as the psychology of decision-making which lies in the gap between economics and psychology. He investigates the implications of relaxing the standard economic assumption that everyone in the economy is rational and selfish, instead entertaining the possibility that some of the agents in the economy are sometimes human.Thaler is the former faculty director of the Center for Decision Research (CDR), a Governoring Board member of the CDR, and the co-director (with Robert Shiller) of the Behavioral Economics Project at the National Bureau of Economic Research.

Getting Nudged

Richard Thaler's book Nudge: Improving Decisions on Health, Wealth, and Happiness -co-authored by Cass Sunstein - examines how small cues, or nudges, can have a major impact on our choices and behavior, and has also gone a long way in popularizing the field of behavioral science by paving the way for broader awareness of other important thinkers and their ideas.
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Cognitive Biases

01 Framing

What is it?

Framing occurs when people make decisions based on the way information is presented, or framed, rather than on the facts themselves. The language used, the physical arrangement of the options, and how we think about a problem are all aspects of a frame. Importantly, the same facts presented in different ways - positive or negative - can lead us to make different decisions.

What are the effects on investors?

When you think about it, it's easy to recognize that most choices are presented in a specific way. Importantly, when faced with two equal choices that are presented differently - one in terms of possibe gains and one in terms of possible losses - investors are likely to choose the one suggesting gains, even if the two choices yield the same end result.

02 Availability

What is it?

This bias occurs when people estimate the probability of an outcome based on how easily the outcome comes to mind. Easily or recently recalled conclusions are often perceived as being more likely than those that are harder to remember or understand. This often makes investors overreact to present market conditions, whether positive or negative.

What are the effects on investors?

Investors may choose an investment or asset class based on something they recently saw or heard rather than on thorough analysis. Overvaluing a particular stock, just because it’s always in the news, is an example.

03 Mental Accounting

What is it?

Mental accounting is when people group their assets into different “buckets” based on arbitrary classifications, such as the source of the assets (salary vs. bonus vs. inheritance, etc.) or their intended use (savings, leisure, etc.), and make very different decisions based on where the money is grouped. The reality is that money is inherently fungible - and financial decisions should be made with this fact in mind.

What are the effects on investors?

Investors may allocate funds into specific buckets, regardless of the correlations between those buckets, which can result in poorly diversified portfolios. For example, investors may divide their assets between safer portfolios and riskier ones on the premise that they can prevent negative returns from speculative investments from impacting their total portfolio.

04 Anchoring

What is it?

Anchoring is the tendency to rely too heavily on the first piece of information we learn, which can have a serious impact on the decisions we make. Once that first piece of information, or “anchor,” is set, our brain makes adjustments based on that anchor.

What are the effects on investors?

Investors may stick too closely to their original estimates when new information becomes available. For example, if an investor estimates next year’s earnings for a company to be $2 per share and the company experiences difficulties during the year, the investor may not adjust their original estimate to account for these challenges because they’re anchored by their original estimate.

05 Confirmation

What is it?

People tend to look for, and notice, evidence that confirms their existing beliefs, ignoring other information that challenges or contradicts their views. This happens as human beings tend to avoid what is technically called “cognitive dissonance” – the mental discomfort that occurs when new information conflicts with our beliefs or perceptions.

What are the effects on investors?

In the investment world, confirmation bias is exhibited repeatedly. As a result, investors ignore negative information about certain assets, which could be a warning sign that can help prevent losses. Investors may also ignore information that supports differing points of view, which can make them miss out on attractive opportunities.

Emotional Biases

As the name suggests, emotional biases stem from emotional factors, like impulse or intuition, which distort cognition and decision making.

Addressing Emotional Biases

Emotional biases are driven by fears and/or desires, unlike cognitive biases, which are mental "short-cuts" that bypass reasoning.

As such, actively working to temper emotions when it comes to investing can lead to better outcomes.

WHAT THE BEHAVIORAL SCIENCE EXPERTS SAY

"The only difference in the way we make sense of our own minds versus other people's minds is that we know we're guessing about the minds of others. The sense of PRIVILEGED access you have to the actual workings of your own mind-to the causes and processes that guide your thoughts and behavior-appears to be an illusion."

- Nicholas Epley

Nicholas Epley

John Templeton Keller Professor of Behavioral Science, Neubauer Family Faculty Fellow, and Center for Decision Research Faculty Director University of Chicago Booth School of BusinessVIEW BIO

Nicholas Epley

Nicholas Epley conducts research on the experimental study of social cognition, perspective taking, and intuitive human judgment. His research appears in more than two dozen journals, including the Journal of Personality and Social Psychology, Psychological Science, and Psychological Review. His research is featured by the Wall Street Journal, CNN, among many others, has been funded by the National Science Foundation, and earned the 2011 Distinguished Scientific Award for Early Career Contributions from the American Psychological Association. He is the 2018 co-recipient of the prestigious Career Trajectory Award by the Society for Experimental Social Psychology (SESP). Epley received a bachelor’s degree in psychology and philosophy in 1996 from Saint Olaf College. In 2001, he graduated from Cornell University with a PhD in psychology.

Being Mindwise

Nick Epley's book Mindwise: Why We Misunderstand What Others Think, Believe, Feel, and Want, explores what scientists have learned about our ability to understand the most complicated puzzle on the planet – other people – and the surprising mistakes we so routinely make.
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Emotional Biases

01 Loss Aversion

What is it?

People typically feel the pain of loss more profoundly than the joy of an equivalent gain. Research has found that some investors need to “win” twice as much as they “lose” to be indifferent to taking risk.

What are the effects on investors?

Loss aversion leads individuals to hold on to losing assets, as they want to avoid the pain of seeing a loss materialized, which only exacerbates losses even more. Similarly, some investors also tend to sell winning assets too early, missing out on further potential gains.

FIND OUT WHY

Loss aversion reflects the human tendency to feel the pain of loss twice as much as the pleasure of gains.

Imagine you are invited to participate in a coin toss where you would win $100 if it lands on heads and lose $100 if it lands on tails. Would you play? If you’re like most people, you’d decline because of the equal chance of losing $100. According to behavioral economists Daniel Kahneman and Amos Tversky, the win, or gain, that would induce people to play is generally about $200 or 2x1 of their losses.1

The pain of losses is twice as painful as the pleasure of gains

1 Kahneman, D. & Tversky, A. (1971). “Belief in the Law of Small Numbers.” Psychological Bulletin. 76 (2): 105-110.

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02 Status Quo

What is it?

Status quo bias is an emotional bias in which people respond to new circumstances by doing nothing instead of making appropriate adaptations. People are generally more comfortable keeping things as they are. This bias might prevent an investor from looking for opportunities where change may be beneficial.

What are the effects?

Investors unwilling to change or adapt to new information may end up with portfolios that are inappropriate given their circumstances, perhaps making an old investment no longer suitable as markets shift. For example, people tend not to shift the allocations in their retirement portfolios even as their time horizon and market cycles change.

03 Endowment

What is it?

The endowment effect makes investors give holdings that they own a disproportionate value simply because they already own them. If the endowment bias didn’t exist, the price that people would be willing to buy would equal the price at which they would be willing to sell – something that rarely happens.

What are the effects on investors?

Investors may hold on to losing or inappropriate assets, instead of selling them, because they are assigning them a disproportionate value. This focus also makes investors miss out on other, perhaps better, opportunities.

04 Regret Aversion

What is it?

Investors want to avoid the pain of regret resulting from a poor investment decision – whether the loss comes from an investment that goes down, or from a perceived loss resulting from a stock that went up, but that they didn’t own. This bias can sometimes initiate herding behavior: investors may buy into an already richly priced and volatile market, helping form a bubble, believing that if they don’t, they will miss out on good opportunities.

What are the effects on investors?

Trying to avoid the pain of regret associated with a bad decision may cause investors to hold onto positions for too long. Regret aversion may also lead to an excess of conservativism, especially if one wants to avoid a repeat of past losses caused, say, by risk assets. This may result in longterm underperformance or in missing one’s financial goals.

05 Overconfidence

What is it?

This bias occurs when people overestimate their own abilities, believing that they are smarter or more informed than they really are. People showing overconfidence may mistakenly equate information quantity with quality, feeling more confident if they have substantial amounts of information, even if its quality is poor.

What are the effects on investors?

Overconfident investors tend to underestimate the risks or overestimate the expected returns of an investment. They also tend to trade excessively – quick to sell an asset that has disappointed them, only to buy a new security that they feel overconfident about.

FIND OUT MORE

In his study of 300 fund managers1, James Montier found that most had overestimated or exaggerated their ablity to outperform — a tendency that is common among people in all professions.

The "Behaving Badly" study highlighted the false sense of confidence that investors can lure themselves into.

74% believed they delivered above-average job performance

26% believed they were average

Nearly 100% felt their performance was average or better, but of course, only 50% of a sample can be above average

1 Montier, James. (2006). "Behaving Badly."

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Additional Resources

 
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Nudging Yourself to Better Investment Decisions

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Narrative Economics

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