By Max Lane, BSc, CIM®, CFP®
Manager, Advisory Services – Associates | Client Relationship Manager
One of a Wealth Advisor’s responsibilities is to uncover clients’ biases and make data-driven decisions to help them preserve and grow their wealth while achieving their goals. Biases can distort how an investor sees reality, and some may lead to poor decisions that can cause damage to wealth. Therefore, it is essential to understand and acknowledge biases to avoid making the wrong choice unintentionally. When searching for a wealth advisor, the investor should be cognizant of possible biases and know when they are present.
A bias can be described as a preference or an inclination—especially one that inhibits impartial judgement—or an unfair act or policy stemming from prejudice1. It is a distorted way of processing information that can lead an investor to make a decision that is not necessarily correct based on the reality of the situation.
Biases in the investment world fall into two major categories: cognitive bias and emotional bias. Cognitive biases are similar to processing errors common to human thinking, whereas emotional biases are similar to an emotional response based on experience. There are 14 significant cognitive biases and six major behavioural biases common to investing.
Major Cognitive Biases
Overconfidence bias is unwarranted confidence in one’s decision-making or intuitive reasoning with minimal basis. An example is an investor who believes they know something the market does not and tries to exploit it. Billions of dollars are spent on equity market research, so it is improbable that the average investor can out-predict the market.
Representativeness bias is the practice of clumping information with similar, but not necessarily the same, information from past experiences and expecting equal future performance. IPOs are a common example. An investor may see massive success in a previous IPO and be more inclined to invest in other IPOs with expectations of seeing similar results, despite fundamental differences in the companies.
Anchoring and Adjustment
Anchoring and adjustment bias is present when one is given information and will perceive any new information with the initial facts in mind. For example, imagine a tourist is shown a hotel room with a fixed price, then brought to another room and told to guess the price. Studies show that the tourist’s knowledge of the initial room’s price significantly impacts their estimate of the second hotel room, compared to if they were given no ‘anchor’ to base their opinion. This example is similar to the investment world when an investor determines an investment’s intrinsic value after being anchored by another figure.
Cognitive dissonance bias comes from discomfort due to new information not coinciding with past information. In general, investors will do their best to avoid being wrong, which can translate into an avoidance of new information which conflicts with their past decisions. The discomfort of being wrong can cause anxiety and negativity within the investor, who will then act to avoid the sensation.
The availability bias is when one makes estimates based primarily on how familiar they are with the information. People typically fall back on the most prevalent example to make a decision instead of evaluating all possible information. Investors sometimes have short-term memory and may think that the most easily recalled information is best. An example would be if someone decided to invest conservatively due to the media’s negative representation of capital markets instead of investing according to their risk tolerance.
The self-attribution bias (also known as the self-serving bias) comes from attributing success to personal action and failure to outside events. This bias is common as investors wish to believe they are successful and will forget bad decisions in favour of good ones. Self-attribution is especially prevalent in active investing, as some investors will attribute good results and decisions to “intuition” or a “hunch” instead of luck.
Illusion of Control
The illusion of control bias is self-explanatory, where investors believe that they have control of events that are outside of their realm of influence. This illusion commonly appears through superstitions, like when a gambler blows on dice or throws them harder, hoping for a better result. An overestimation of personal influence can lead to frustration or unfounded positive reinforcement for investors who will assign blame to themselves when their actions do not positively affect the situation.
The conservatism bias comes from one who chooses to avoid information that contradicts their beliefs. This bias is responsible for the rejection of new information and refusal to change investment strategy, despite evidence in favour of adjustment. Under-reaction to new information in investing can be quite dangerous as investors may stick to a failing investment strategy despite early warning signs against it.
The ambiguity aversion bias is when one avoids decisions or risks when the probability is unknown. A common example would be if someone were to bet on a ball being red or blue when pulled from a container. They would often prefer to place a bet if it was a known fact that the colours were split 50/50, as opposed to an unknown distribution. Another example is that many investors will typically invest in an arena they know instead of taking a chance and investing in a new area where the outcomes are unknown. Older investors generally are known to exhibit this type of bias.
Mental accounting bias describes the tendency to categorize and evaluate economic outcomes by grouping assets into non-fungible (non-interchangeable) mental accounts2. We can often see this when one receives their tax refund. The refund typically comes from too much tax withheld from their pay. The money has always been theirs from the beginning; however, one is more likely to spend their tax refund recklessly than if they had those funds saved up from before. Investors also exhibit mental accounting with “core and explore” strategies, holding a “safe” portfolio and investing speculatively with another portion instead of a unified investment strategy.
Confirmation bias is a selective memory fault where one will emphasize information that confirms their beliefs while degrading information that opposes them. This bias can cause investors to strengthen incorrect strategies while ignoring new information to the contrary and, over time, have a significantly wrong view of their situation. An everyday example is when a person believes bad drivers drive a particular car model. As a result, they will always remark when they see a driver in that specific car do something wrong and often not comment when another type of car does something similar. Confirmation bias can be particularly dangerous long term as, over time, it can cause significant distortion of the view of markets and wealth strategies.
Hindsight bias is when one feels that they could have predicted an outcome. Many factors lead to events, such as price increases for a security, and repeating similar actions will not necessarily lead to similar results. Frustrations may arise as investors feel that missed successes could have been predicted, making them more prone to poor decision-making on similar events in the future. This act can be dangerous as it is easy to forget that past performance does not indicate future results.
The recency bias is when one focuses on short-term data instead of considering the long-term. Investors are particularly vulnerable to this bias as many will only think short-term (less than one year) when considering an investment when a much longer time horizon should be used. An example would be that a sharply increasing stock is seen as a good investment when, in fact, it could be a cyclical stock, and a downturn could be imminent as the stock is already fully valued.
Framing bias is the tendency to see situations differently, depending upon the surrounding circumstances. An everyday example is when a person goes to the grocery store and sees deals like buy two for $5. Even though the price is always $2.50 each, people will view it as a deal and buy two at a time. This bias is used in the media and investment sales to influence investors’ emotional responses. The framing of a statement should have no bearing on the underlying data of deciding, so it should not affect investment decisions, but it does.
Endowment bias is when an investor places more value upon investments that they own, as opposed to investments that they do not. This bias can lead to investors unnecessarily holding onto investments despite the availability of a more favourable alternative.
Self-control bias is when one puts short-term needs ahead of long-term needs. Disregarding future consequences can cause people to be impulsive and act on something immediately without carefully considering the available data. Many investors realize their lack of self-control and will opt for funds to be withheld from them to avoid making bad decisions.
Optimism bias is the tendency to overestimate our chances of positive experiences and underestimate our chances of negative experiences. For example, things can go wrong in the investment market, yet those with an optimism bias believe these negative things will not happen to them. Or, at least, things will not be as bad for them.
Loss aversion bias occurs when someone feels so strongly against taking a loss that they primarily focus on avoiding losses ahead of achieving gains3. The motivation to prevent a loss is nearly twice as powerful as the motivation to obtain a gain of equal magnitude. To illustrate, we imagine a person is offered a 50/50 chance of winning $100 or losing $75; the person with a loss aversion bias will most likely avoid participating for fear of potentially losing out. This fear can lead to unnecessarily conservative investment decisions that inhibit potential gains.
The regret aversion bias is when one avoids decision-making because they fear that they will regret having made that decision. The regret-averse investor will focus on the regret felt from the worst possible situation after a decision and base their action on that. This decision paralysis will lead to overweighting the probability of a negative outcome and may lead to an inappropriately conservative strategy.
Status quo bias is the preference for maintaining one’s current situation over changing it. In investing, this can lead to unnecessary emotional attachments to securities and lead to investors’ tendency to hold onto a failing investment instead of exploring the options.
Becoming familiar with these biases can help an investor avoid possible mistakes when selecting an investment or wealth advisor. In addition, once a bias has been identified, the investor can step back and process the information again to make a more data-driven, responsible choice to make wealth management decisions that coincide with their long-term goals.
1 The American Heritage Dictionary of the English Language, Fifth Edition. Copyright 2015 by Houghton Mifflin Harcourt Publishing Company.
2 Thaler, R. H. “Towards a positive theory of consumer choice.” Journal of Economic Behaviour and Organization, 1, 1980, 39-60.
3 Kahneman and Tversky, “Prospect theory: An analysis of decision under risk”. Econometrica, 47, 1979, 263-291.
4 Canadian Securities Institute, “What Are Investment Biases”. Advanced Investment Strategies, 92-97, 2016
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.