Francis Gingras Roy explains the six most common investment biases and provides tips on how advisors can help clients deal with them.
As humans, we have built in and learned bias. A “bias” is an unfounded or illogical inclination that we hold to be true or prejudice based on who we are and how we were raised.
When it comes to money, our personal bias will direct how we make investments and our investment style. Because money is personal, it reflects and affects our life and lifestyle—and our personal bias will affect how we judge an investment. A particular bias will affect our ability to make decisions based on facts and evidence, because that bias will create an inclination to ignore whatever doesn’t line up with our mindset.
Whenever an investor takes a “biased action,” they are failing to recognize anything that might contradict their belief. Instead, the investor believes that the investment strategy they use will automatically lead to improved returns and greater wealth. Investment bias is affected by factors such as panic, overconfidence, and a desire for control, any or all of which can lead to poor decision-making.
Therefore, it is very important to understand the different types of investment bias so that we can understand why and how we make investment choices, and to help clients from making poor choices. Here are the most common types of investment bias and how they affect our decision-making process:
Anchoring bias
Relying too heavily on information received first
Anchoring is most commonly used in facets of retail shopping, such as groceries, clothing and car shopping.
Confirmation bias
Seeking out information that confirms an existing belief
Confirmation bias is the natural tendency to filter out information to retain only what confirms one's original belief.
Recency bias
Basing decisions only on the most recent information
Recency bias is when individuals make decisions based on recent results, or on their perspective of recent results, which may lend itself to making incorrect conclusions based on the recent past.
Herding bias
Following the crowd instead of making decisions
Herding bias is the tendency to follow the actions of a larger group, whether those actions are rational or irrational. It is rooted in early human behaviour.
Ambiguity aversion
A tendency to avoid the unknown
Ambiguity aversion is the tendency to avoid the unknown by having a preference for known risks over unknown risks.
Myopic loss aversion
Experiencing more sensitivity to losses than gains
Myopic loss aversion is the combination of a greater sensitivity to losses than to gains and a tendency to evaluate outcomes frequently.
Once these biases are recognized, investors should be encouraged to address any behavioural challenges that may hinder success. Here are some key pointers to explain to clients:
Anchoring bias
- Acknowledge the anchor when making decisions.
- Understand, address and remember the goal—not the dollars.
- Recognize that the ways choices are presented will affect the decision.
Recency bias
- Yesterday's truth is not tomorrow's.
- No pattern continues forever.
Ambiguity aversion
- Goal-based planning is key to success.
- Outcomes should drive your actions, not fear of the unknown.
Confirmation bias
- Admit that different situations call for different expertise.
- Seeking out confirmation of options is a surefire way to "group think".
Herding bias
- Running with the crowd may prevent solitary embarrassment but won't keep you from being wrong.
- By the time everyone is heading a particular direction, it's usually time to start heading the other way
Myopic loss aversion
- Financial losses are often "locked in" by panic selling.
- Keep a focus on the long-term goals in order to drive success
It is interesting to know that Wikipedia notes that there are over one hundred identified cognitive biases. Each of these can have an effect on an individual investor, depending on their temperament. The six investment biases listed here are the most common, and most investors will identify with at least one of them. The question then to ask clients is, “What can I do to recognize which bias(es) affect my investment decision-making and what can I do to limit the effects?”
More details on Francis Gingras Roy’s book, The Investment Revolution, can be found here.
