Biases, biases, biases

Biases are everywhere in life and to improve as an investor, knowing about our biases is the crucial first step before tackling them and improving our investment process. Here I will provide a list of biases …

I recently read (and re-read) a few books about the topic of biases and became strongly interested in them. I want to become much more aware of biases and ultimately strongly improve my investment process.

A note: Obviously, this list is not exhaustive and if you think there are biases missing that are very relevant for investors, please leave a comment below. Many biases are known with various names.

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Anchoring bias. We tend to rely too heavily on past references, often one piece of information, when we make a decision. Investors evaluate (or merely compare) the current price of a stock against yesterday’s price and draw conclusions. If we already own the stock, we compare against our initial buy price.  

Status quo bias. Once we own something (like a stock), we place a higher value on it than others would. This is also called inaction inertia, or endowment effect.  

Conservatism refers to investors’ tendency to change their opinions too late (if at all) not considering new information to update their believes. In the financial industry it can be observed that equity analysts update their EPS estimates far too slowly, even in the eye of an economic downturn. Spotting regime changes seems to be particularly hard. 

Empathy gaps. We are not good at judging our future selves, i.e., after finishing a big meal, we cannot imagine ever being hungry again. Usually, our future behaviour will be very different from optimal or planned. We over-estimate our future behaviour, especially for the heated moments to come, i.e., during market sell offs: Buying cheap is harder than it sounds and imagined before assets crash.

(Over-) Optimism might be an advantage in life (how else to hunt a mammoth) but hope is not a good investment strategy but we make it even worse through our …

Over-confidence: We constantly over-estimate our abilities and tend to think we could control the outcome. This gets amplified by:

• Confirmation bias (also inattentional blindness, motivated reasoning, biased assimilation) is the tendency to search for, interpret, favour, and recall information in a way that confirms and supports one’s prior beliefs or values. 
• Authority. We are terribly overconfident and experts even more so. Unfortunately, we use confidence as a proxy for skill. As investors we must be careful not to trust experts or so called ‘authorities’.
• Self-serving bias. We have an innate desire to interpret information and act in ways that are supportive of our own self-interests. Thus, we attribute our positive (investment) results to our positive skill and negative results to bad luck.

Action bias. Investors prefer action over inaction, just like goal keepers. Worse, when dealing with losses, our urge for action (buying or selling) is exceptionally high.

Hindsight bias. After the future unfolded, we can hardly imagine that history took another path. Once we know the outcome we tend to think we knew it all the time.  

Narrative fallacy. We tend to abandon evidence (facts) in favour of a good story. Investors prefer to own admired stocks with a good story which have done well, both in stock market performance and their financial performance. Investors nearly always overpay for the hope of growth.

Bandwagon effect. We feel pain when going against the crowd (being contrarian) and we feel good when surrounded by (dangerous) groupthink. Groups tend to form a common view (direction), to build a more extreme view (farther from the centre) and become ever more certain (discounting alternatives). This is also present with regard to investment style: we surround us with similar investors which results in group think.

Loss aversion. Losing an amount feels more painful than winning the same amount. 

• Myopia, our focus on the short term, is multiplying our pain since we investigate our portfolios too often (increasing the chance to see a loss due to short term volatility). 
• Disposition effect. We believe a loss is not a loss until we realize it, thus we hold onto our losing stocks (and sell our winners instead).  

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When we are more aware of our biases the next logical step is to improve our investment process … but that is the topic of another article.

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