Behavioral Bias in Investing: A Primer

There’s been a lot written about bias – the decision-making shortcuts our brains naturally and inevitably take to navigate through the myriad decisions we have to make each day. These biases influence investment conclusions in ways we’re often unaware of. Crescente Advisors believes combining actionable self-awareness (particularly risk tolerance and strengths) with proven strategies to mitigate cognitive and emotional bias provides investors with an edge. 

This is the first blog in a series of actionable and practical steps investors can take to deal with unwanted bias. We cover common behavioral bias we see show up in investment processes.  In a future blog, we’ll share strategies investors - both as individuals and as teams – can take to mitigate bias.

For more in depth research on bias and its impact, we point you towards the work of a range of academics including psychologists Mahzarin Banaji, economists Daniel Kahneman, Amos Tversky and Dan Ariely and finance professionals including Michael Mauboussin. 

Common Behavioral Biases

While not exhaustive, this list contains many of the most common biases we see in investment professionals and portfolio teams. 

Anchoring Bias (also called Conservatism bias)

• Relying heavily on the first piece of information offered when considering a decision and considering new information in the context of this first piece

• Clinging to prior views or forecasts at the expense of incorporating new information

Availability Bias
Overestimating the value of readily available information to enable quick decisions and judgments

Bandwagon Effect (also called Trend Chasing or Herd Mentality)

• Acting primarily because others are or FOMO (Fear of Missing Out)

• Conforming behavior/beliefs to those of a group

 Confirmation Bias

• Searching for or interpreting information that confirms preconceptions

• Interpreting ambiguous evidence as supporting an existing position

• Giving more weight to information that supports current beliefs

Endowment Effect
Belief that what is already owned is more valuable than similar assets not owned.

Framing Effect
Drawing differing conclusions from the same information based on the way it is presented or by whom.

Illusion of Control

• Overestimating control over the outcome of a situation when isn’t possible.  Contributing factors include:

  • familiarity with situation

  • previous experiences

  • emotion/mood

• Can lead to taking excessive risk

Information Bias

• Continuing to seek information beyond what is necessary to take action. 

• Believing that more information is always better – Analysis paralysis

Loss Aversion

• Resisting taking action by focusing more on what might be lost rather than what might be gained

• Pain of losing is psychologically twice as powerful as the pleasure of gaining

Neglect of Probability

• Downplaying or disregarding probability when making a decision when there’s uncertainty

• Small risks are typically either neglected entirely or hugely overrated

Normalcy Bias (also known as Ostrich Effect)
Avoiding or ignoring facts that create anxiety or unpleasant emotions

Outcome Bias
Measuring the success/efficacy of a decision based on its outcome rather than focusing on the quality of the decision AT THE TIME IT IS MADE

Overconfidence
Excessive faith in the quality of information, skill, judgement and ability to act on information at the right time

Proximity Bias
Having more conviction in inputs that are “close” in terms of time, geography, or familiarity

Recency Bias
Estimating future probabilities based on recent observations or outcomes instead of a longer-term time horizon.

Regret Aversion
Avoiding taking action out of fear a decision will turn out to be wrong

Restraint Bias
Overestimating the ability to manage emotion and impulsiveness.   

Status Quo Bias

• Preferring the current state of affairs or sticking with a decision already made

• Believing that when changes occur, they represent loss or detriment

---

Conclusion

Unchecked, biases impact all kinds of decision-making including buying, sizing and selling securities and team interactions.  Understanding bias and your own personality, especially your risk appetite, enable you to design process and improve outcomes. In our next blog, we’ll explore strategies for both individuals and teams to mitigate different forms of biases.

For more information, contact Christine at CScordato@CrescenteAdvisors.com.