This is the second part of an introductory series of articles on behavioral biases in investing. These biases can be subtle and can be difficult to spot, even for the most trained investor. Sometimes, it might be difficult to correct an existing bias even if an investor is already well aware of its existence.
This time, we talk about a different set of biases, which again can affect beginner and expert investors alike.
Anchoring Bias A bias is often seen in transactions, it affects investors when they set an “anchor”, which could be a price they think a stock should be trading at or a price for which an asset they own should be worth and make all other decisions accordingly.
For example, an investor might take the price he entered a position in a stock as an “anchor”, in the sense of making all future decisions based on that price (for example, I sell when I am 20% above my entry price or 20% above $100, etc.).
This bias also involves setting arbitrary levels of indexes or stocks as meaningful “milestones” (ex. The SP500 index has reached 3000 points, or Tesla stock is now worth $400). Not surprisingly, this bias is often reinforced by financial news media organizations.
Mental Accounting Bias
A more subtle investing bias, mental accounting, involves dividing money and wealth in “buckets”, for example using dividend income for current expenses and always keeping 10% of the salary for savings. This bias ignores the correlation between investments and mistakenly divides wealth into buckets, instead of considering it as a whole.
Availability Bias This bias instead leads people to estimate the probability of an outcome basing their decision on how easily the outcome comes to mind. Therefore, easily recalled outcomes are perceived as being more likely, even though this is often not the case in practice.
This bias is closely connected to the concept of “retrievability”, which means that usually, the first idea that comes to mind is the one most likely to be followed, given the cognitive cost of acquiring or remembering other information.
Loss-Aversion Bias Probably one of the most important biases, loss aversion is the tendency of weighting a loss comparably more than an equivalent gain (this is valid both in monetary and non-monetary terms, although it might be difficult to quantify empirically in the latter case).
To better explain, it has been shown that a loss of $1000 inflicts a greater pain in absolute terms on an investor than the amount of pleasure derived by a $1000 gain.
This leads in practice to investors selling winners too early and selling losers too late, a behavior also called “disposition effect”. In other words, more risk is acceptable to avoid losses than to achieve gains, holding everything else equal.
Overconfidence Bias A bias which can be found in many other fields outside of finance, overconfidence bias (also known as superiority bias or above-average effect) has to do with people showing excessive faith in their own judgment and abilities, such as intuitive reasoning.
For example, a famous survey of male drivers in the United States showed that 80% of all male drivers believed that they were better drivers than the average. People have indeed shown a tendency, which can be stronger in some than in others, to take merit for positive achievements and blame external factors for negative outcomes.
Curiously, some studies have linked the presence of higher levels of testosterone in men as a possible determinant of overconfidence, given that this behavior is observed in a lot of other fields and even in different animal species.
Endowment Bias
This is a very common bias, and it entails people putting a greater value on an asset when the asset is owned (compared to when it is not). This bias can result in investors failing to sell a certain stock even in face of overwhelming evidence of it being a bad investment.
Last but definitely not least, this bias is probably one of the most common and can also be found in multiple real-life domains outside of finance. Self-control bias involves trading long-term goals for short-term satisfaction, given that long-term goals are far in the future and usually difficult to value in terms of present costs.
People, especially but not only less educated ones, often lack the self-discipline to prepare for the long-term, because of the tangibility of short-term gains vs uncertainty of future outcomes. This bias is closely related to the concept of hyperbolic discounting, which simply describes the human tendency in overvaluing short-term small payoffs over larger future gains.
Conclusion This is not an exhaustive list of biases affecting investment decision making, and many more biases exist and are being discovered and studied as the discipline of behavioral economics and finance develops. Moreover, most of the biases described in these two articles often are known with other names and can be described differently in different textbooks and/or articles.
Nevertheless, every investor should be well aware of their existence and try to identify as many as he/she can before making investment decisions.
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