20 Behavioral Biases
Some financial advisors are needlessly struggling with behavioral finance because they lack a systematic way to apply it to their client relationships. In my 2006 book, Behavioral Finance and Wealth Management, I outline a method of applying behavioral finance to private clients in a way that I now refer to as "bottom-up." This means that for financial advisors to diagnose and treat behavioral biases, he or she must first test for all behavioral biases in a client, and then determine which ones a client has before being able to use bias information to create a customized investment plan. In my book I describe the most common behavioral biases an advisor is likely to encounter, explain how to diagnose these biases, show how to identify behavioral
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investor types, and finally show how to plot this information on a chart to create the client's "best practical allocation." But some advisors may find this bottom-up approach too time-consuming or complex. So, I created a simpler, more efficient approach to bias identification that is "top-down," a shortcut if you will, that can make bias identification much easier. I call it Behavioral Alpha, and the core of this process is four behavioral investor types.
Over the next four articles, we will learn the four behavioral investor types and how to deal with each of these types of investors.
For readers to understand behavioral investor types, they need to get a fundamental understanding of the 20 behavioral biases I outline in my book. In this article, we will review these biases that are encountered with actual clients, with a description of the bias and a classification of whether the bias is cognitive or emotional. Behavioral biases fall into two broad categories, cognitive and emotional, with both varieties yielding irrational judgments. A cognitive bias can be technically defined as a basic statistical, information processing, or memory error common to all human beings. They also can be thought of as "blind spots" or distortions in the human mind. Cognitive biases do not result from emotional or intellectual predisposition toward a certain judgments, but rather from subconscious mental procedures for processing …show more content…
information.
On the opposite side of the spectrum from illogical or distorted reasoning we have emotional biases. Although emotion is a difficult word to describe and has no single universally accepted definition, an emotion is a mental state that arises spontaneously, rather than through conscious effort. Emotions are physical expressions, often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, in reality or in the imagination. Emotions can be undesired to the individual feeling them; he or she might wish to control their emotions but often cannot. Investors can be presented with emotionally based investment decisions, and may make suboptimal decisions by having emotions affect these decisions. Often, because emotional biases originate from impulse or intuition rather than conscious calculations they are difficult to correct. Emotional biases include endowment, loss aversion, and self-control. We will investigate both cognitive and emotional biases in the next section.
The distinction between cognitive and emotional is an important one, because advisors will want to advise their clients differently based on which types of biases are being acted out. In the next four articles, we will use the biases described here a lot, so I encourage readers to get to know the biases presented here in concept. We will apply them to client situations in subsequent articles.
Loss Aversion Bias
Bias Type: Emotional
Some investors feel the pain of losses more than the pleasure of gains--the essence of loss aversion. This bias prevents people from unloading unprofitable investments, even when they see no prospect of a turnaround. Some industry veterans have coined a diagnosis, "get-even-itis" to this phenomenon.
Continued from page 1.
Status Quo Bias
Bias Type: Emotional
Status quo bias predisposes investors, when facing an array of choice options, to elect whatever option keeps conditions the same. Some investors tell themselves "things have always been this way" and thus keep things the same.
Endowment Bias
Bias Type: Emotional
Endowment bias occurs when investors assign greater value to a security that he or she possess and is faced with its loss, than when he or she doesn't possess the security and has the potential to acquire it.
Regret Aversion Bias
Bias Type: Emotional
Investors exhibiting regret aversion bias avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause investors to be too conservative in their investment choices because of losses in suffered the past.
Anchoring Bias
Bias Type: Cognitive
Anchoring bias occurs when investors are influenced by purchase points or arbitrary price levels, and tend to cling to these numbers when facing questions like "should I buy or sell this investment?" Suppose that the stock is down 25% from its high that it reached five months ago ($75/share versus $100/share). Frequently, a client will be resistant to sell the stock until its price rebounds to the $100/share it achieved five months ago. This is anchoring bias.
Mental Accounting Bias
Bias Type: Cognitive
Mental accounting bias occurs when people treat various sums of money differently based on where these sums are mentally categorized. For example, some risk-averse investors segregate their assets into safe "buckets." If all of these assets are viewed as "safe money" suboptimal returns are usually the result.
Recency Bias
Bias Type: Cognitive
Recency bias is a predisposition of investors to more prominently recall and emphasize recent events and/or observations and potentially extrapolate patterns where none exist.
For example, recency bias occurs when investors wrongly presume that market gains will continue forever and then will enter an asset class when prices are peaking, which can end badly with sharp price declines.
Continued from page 2.
Hindsight Bias
Bias Type: Cognitive
Some investors lack independent thought on investments and are susceptible to hindsight bias which occurs when an investor perceives investment outcomes as if they were predictable--even if they weren't. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, and thus excessive risk is taken.
Framing Bias
Bias Type: Cognitive
Framing bias is the tendency of investors to respond to various situations differently based on the context in which a choice is presented (framed). Often, investors focus too restrictively on one or two aspects of an investment situation, excluding critical considerations. The use of risk tolerance questionnaires provides a good example. Depending upon how questions are asked, framing bias can cause investors to respond to risk-tolerance questions in an either unduly conservative or risk-taking
manner.
Cognitive Dissonance Bias
Bias Type: Cognitive
In psychology, cognitions represent attitudes, emotions, beliefs or values. When multiple cognitions intersect--for example a situation arises in which a person believes in something only to find out it is not true--they try to alleviate their discomfort by ignoring the truth and rationalizing their decision to ignore the truth. Investors will sometimes act out this behavior when making their own investment decisions.
Ambiguity Aversion Bias
Bias Type: Cognitive
Ambiguity aversion is a difficult bias to explain; therefore an example works best. Suppose a researcher asks Mr. Jones his prediction as to the outcome of an ambiguous situation: whether a certain sports team will win its upcoming game. Suppose the estimate given is 60% that the team wins. Further suppose the researcher presents Mr. Jones with a 50%/50% slot machine, which offers no ambiguity, and then asks which bet is preferable. If Mr. Jones is ambiguity-averse, he will choose the slot machine, even if he feels confident about the team winning. Translating this idea to the investment world, even when investors feel skillful or knowledgeable, they might not be willing to stake claims on "ambiguous" investments like stocks, even when they believe they can predict these outcomes based on their own judgment.
Conservatism Bias
Bias Type: Cognitive
Conservatism bias occurs when investors cling to a prior view or forecast at the expense of acknowledging new information. Some investors who make their own investment decisions cling to a view they perceive as likely to happen, behaving too inflexibly when presented with contradictory information.
Continued from page 3.
Availability Bias
Bias Type: Cognitive
Availability bias occurs when investors estimate the probability of an outcome based on how prevalent that outcome is in their lives. For example, investors exhibiting this bias perceive easily recalled investment options, such as mutual fund companies that advertise a lot, as better options than those that are less "available" to investors such as those that don't advertise.
Representativeness Bias
Bias Type: Cognitive
Representativeness bias occurs as a result of a flawed perceptual framework when processing new information. To make new information easier to process, some investors project outcomes that resonate with their own pre-existing ideas. An II might view a particular stock, for example, as a value stock because it resembles an earlier value stock that was a successful investment--but the new investment is actually not a value stock.
Self-Attribution Bias
Bias Type: Cognitive
Self-attribution bias refers to the tendency of people to ascribe their successes to innate talents while blaming failures on outside influences. If an investment does well, that success is due to the investment talent of the investor; if an investment does poorly, that failure was due to external forces.
Confirmation Bias
Bias Type: Cognitive
Confirmation bias occurs when investors observe, overvalue, or actively seek out information that confirms their investment ideas, while ignoring or devaluing evidence that might discount their investment ideas.
Overconfidence Bias
Bias Type: Cognitive and Emotional
Overconfidence is best described as unwarranted faith in one's own thoughts and abilities--which contains both cognitive and emotional elements. Overconfidence manifests itself in investors' overestimation of the quality of their judgments.
Illusion of Control Bias
Bias Type: Cognitive
The illusion of control bias occurs when investors believe that they can control or, at least, influence investment outcomes when, in fact, they cannot. Investors who are subject to illusion of control bias often believe that the best way to manage an investment portfolio is to constantly adjust it.
Self-Control Bias
Bias Type: Emotional
Self-control bias is the tendency to consume today at the expense of saving for tomorrow. The primary concern for advisors with clients having this bias is a high risk tolerance coupled with high spending.
Optimism Bias
Bias Type: Emotional
Many overly optimistic investors believe that bad investments will not happen to them--they will only afflict "others." Such an illusion can damage portfolios because people fail to mindfully acknowledge the potential for adverse consequences in the investment decisions they make.
investor types, and finally show how to plot this information on a chart to create the client's "best practical allocation." But some advisors may find this bottom-up approach too time-consuming or complex. So, I created a simpler, more efficient approach to bias identification that is "top-down," a shortcut if you will, that can make bias identification much easier. I call it Behavioral Alpha, and the core of this process is four behavioral investor types.
Over the next four articles, we will learn the four behavioral investor types and how to deal with each of these types of investors.
For readers to understand behavioral investor types, they need to get a fundamental understanding of the 20 behavioral biases I outline in my book. In this article, we will review these biases that are encountered with actual clients, with a description of the bias and a classification of whether the bias is cognitive or emotional. Behavioral biases fall into two broad categories, cognitive and emotional, with both varieties yielding irrational judgments. A cognitive bias can be technically defined as a basic statistical, information processing, or memory error common to all human beings. They also can be thought of as "blind spots" or distortions in the human mind. Cognitive biases do not result from emotional or intellectual predisposition toward a certain judgments, but rather from subconscious mental procedures for processing …show more content…
information.
On the opposite side of the spectrum from illogical or distorted reasoning we have emotional biases. Although emotion is a difficult word to describe and has no single universally accepted definition, an emotion is a mental state that arises spontaneously, rather than through conscious effort. Emotions are physical expressions, often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, in reality or in the imagination. Emotions can be undesired to the individual feeling them; he or she might wish to control their emotions but often cannot. Investors can be presented with emotionally based investment decisions, and may make suboptimal decisions by having emotions affect these decisions. Often, because emotional biases originate from impulse or intuition rather than conscious calculations they are difficult to correct. Emotional biases include endowment, loss aversion, and self-control. We will investigate both cognitive and emotional biases in the next section.
The distinction between cognitive and emotional is an important one, because advisors will want to advise their clients differently based on which types of biases are being acted out. In the next four articles, we will use the biases described here a lot, so I encourage readers to get to know the biases presented here in concept. We will apply them to client situations in subsequent articles.
Loss Aversion Bias
Bias Type: Emotional
Some investors feel the pain of losses more than the pleasure of gains--the essence of loss aversion. This bias prevents people from unloading unprofitable investments, even when they see no prospect of a turnaround. Some industry veterans have coined a diagnosis, "get-even-itis" to this phenomenon.
Continued from page 1.
Status Quo Bias
Bias Type: Emotional
Status quo bias predisposes investors, when facing an array of choice options, to elect whatever option keeps conditions the same. Some investors tell themselves "things have always been this way" and thus keep things the same.
Endowment Bias
Bias Type: Emotional
Endowment bias occurs when investors assign greater value to a security that he or she possess and is faced with its loss, than when he or she doesn't possess the security and has the potential to acquire it.
Regret Aversion Bias
Bias Type: Emotional
Investors exhibiting regret aversion bias avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause investors to be too conservative in their investment choices because of losses in suffered the past.
Anchoring Bias
Bias Type: Cognitive
Anchoring bias occurs when investors are influenced by purchase points or arbitrary price levels, and tend to cling to these numbers when facing questions like "should I buy or sell this investment?" Suppose that the stock is down 25% from its high that it reached five months ago ($75/share versus $100/share). Frequently, a client will be resistant to sell the stock until its price rebounds to the $100/share it achieved five months ago. This is anchoring bias.
Mental Accounting Bias
Bias Type: Cognitive
Mental accounting bias occurs when people treat various sums of money differently based on where these sums are mentally categorized. For example, some risk-averse investors segregate their assets into safe "buckets." If all of these assets are viewed as "safe money" suboptimal returns are usually the result.
Recency Bias
Bias Type: Cognitive
Recency bias is a predisposition of investors to more prominently recall and emphasize recent events and/or observations and potentially extrapolate patterns where none exist.
For example, recency bias occurs when investors wrongly presume that market gains will continue forever and then will enter an asset class when prices are peaking, which can end badly with sharp price declines.
Continued from page 2.
Hindsight Bias
Bias Type: Cognitive
Some investors lack independent thought on investments and are susceptible to hindsight bias which occurs when an investor perceives investment outcomes as if they were predictable--even if they weren't. The result of hindsight bias is that it gives investors a false sense of security when making investment decisions, and thus excessive risk is taken.
Framing Bias
Bias Type: Cognitive
Framing bias is the tendency of investors to respond to various situations differently based on the context in which a choice is presented (framed). Often, investors focus too restrictively on one or two aspects of an investment situation, excluding critical considerations. The use of risk tolerance questionnaires provides a good example. Depending upon how questions are asked, framing bias can cause investors to respond to risk-tolerance questions in an either unduly conservative or risk-taking
manner.
Cognitive Dissonance Bias
Bias Type: Cognitive
In psychology, cognitions represent attitudes, emotions, beliefs or values. When multiple cognitions intersect--for example a situation arises in which a person believes in something only to find out it is not true--they try to alleviate their discomfort by ignoring the truth and rationalizing their decision to ignore the truth. Investors will sometimes act out this behavior when making their own investment decisions.
Ambiguity Aversion Bias
Bias Type: Cognitive
Ambiguity aversion is a difficult bias to explain; therefore an example works best. Suppose a researcher asks Mr. Jones his prediction as to the outcome of an ambiguous situation: whether a certain sports team will win its upcoming game. Suppose the estimate given is 60% that the team wins. Further suppose the researcher presents Mr. Jones with a 50%/50% slot machine, which offers no ambiguity, and then asks which bet is preferable. If Mr. Jones is ambiguity-averse, he will choose the slot machine, even if he feels confident about the team winning. Translating this idea to the investment world, even when investors feel skillful or knowledgeable, they might not be willing to stake claims on "ambiguous" investments like stocks, even when they believe they can predict these outcomes based on their own judgment.
Conservatism Bias
Bias Type: Cognitive
Conservatism bias occurs when investors cling to a prior view or forecast at the expense of acknowledging new information. Some investors who make their own investment decisions cling to a view they perceive as likely to happen, behaving too inflexibly when presented with contradictory information.
Continued from page 3.
Availability Bias
Bias Type: Cognitive
Availability bias occurs when investors estimate the probability of an outcome based on how prevalent that outcome is in their lives. For example, investors exhibiting this bias perceive easily recalled investment options, such as mutual fund companies that advertise a lot, as better options than those that are less "available" to investors such as those that don't advertise.
Representativeness Bias
Bias Type: Cognitive
Representativeness bias occurs as a result of a flawed perceptual framework when processing new information. To make new information easier to process, some investors project outcomes that resonate with their own pre-existing ideas. An II might view a particular stock, for example, as a value stock because it resembles an earlier value stock that was a successful investment--but the new investment is actually not a value stock.
Self-Attribution Bias
Bias Type: Cognitive
Self-attribution bias refers to the tendency of people to ascribe their successes to innate talents while blaming failures on outside influences. If an investment does well, that success is due to the investment talent of the investor; if an investment does poorly, that failure was due to external forces.
Confirmation Bias
Bias Type: Cognitive
Confirmation bias occurs when investors observe, overvalue, or actively seek out information that confirms their investment ideas, while ignoring or devaluing evidence that might discount their investment ideas.
Overconfidence Bias
Bias Type: Cognitive and Emotional
Overconfidence is best described as unwarranted faith in one's own thoughts and abilities--which contains both cognitive and emotional elements. Overconfidence manifests itself in investors' overestimation of the quality of their judgments.
Illusion of Control Bias
Bias Type: Cognitive
The illusion of control bias occurs when investors believe that they can control or, at least, influence investment outcomes when, in fact, they cannot. Investors who are subject to illusion of control bias often believe that the best way to manage an investment portfolio is to constantly adjust it.
Self-Control Bias
Bias Type: Emotional
Self-control bias is the tendency to consume today at the expense of saving for tomorrow. The primary concern for advisors with clients having this bias is a high risk tolerance coupled with high spending.
Optimism Bias
Bias Type: Emotional
Many overly optimistic investors believe that bad investments will not happen to them--they will only afflict "others." Such an illusion can damage portfolios because people fail to mindfully acknowledge the potential for adverse consequences in the investment decisions they make.