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10 investor behavioural biases to look out for

  • Describe what behavioural finance is
  • Explain some of the biases that creep into investor behaviour
  • Identify some of the dangers that come with behavioural biases
CPD
Approx.30min

We are not logical but psycho-logical: prone to lazy thinking which can easily get us into trouble. But being self-aware of the potential of bias can help all of us avoid errors. The list of biases is long, but some are more salient in these unusual times.

Four of the most common of all these biases may however show a decline in these unusual times

  1. Over confidence: Success is not a great teacher, and those with a “run of good luck” can become arrogantly hubristic and naively optimistic. People will deal with their investment mistakes in different ways, but there can be few who can say “I told you so; I predicted this: I have been here before and know what to do”. Some have had their bravado and over-confidence knocked out of them so much that they go to the opposite extreme of being unable to function rationally. Clearly all extremes of confidence are bad for one. It is unlikely that people will show over-confidence bias much at the present time: but if they do then challenge or avoid them, since it may be a symptom of a failure to learn or of self-deception.
  2. Illusions of Control When subject to this bias, people feel as if they can exert more control over their business and financial environment than they actually can. This often leads investors to trade more than is advisable as well as under‐diversified portfolios. Few indeed are likely to feel they can control anything given what they are hearing the boffins try and predict regarding the epidemic. The instrumentalist can easily become the fatalist in these times.
  3. Crowd-Following and Herding: This is the ‘bandwagon effect’. It is to believe that the “trend is your friend” and a “word from the herd” and “everybody’s doing it” imparts good advice. But what are the experts doing and saying now? Is there a trend emerging that is worth following? This may still come but is not yet here. Some, no doubt “tune into” what the sages advise but there seems no clear trend at the moment.
  4. Familiarity This heuristic works on the basis of current behaviour being similar to a past experience. We assume that previous behaviour and its results can be applied to new situations - even this one. It is taking a scientific approach to problem-solving. What worked in the (very different) past will work in current (and future) situations. This is all about habits that need to be given up. In this sense we are “victims” of our past. It also explains why people learn more from failure than from success. The deja vu experience, then, can be very bad for us if prior learning is not remodelled to the current context.

However, there are other biases which may indeed increase in these times. They are:

  1. Paralytic loss aversion – short term views on investment characterized by a high sensitivity to losses. We tend to treat losses and gains quite differently. Most of us are much more willing to take risks to avoid losses and are much more conservative when it comes to opportunities for gain.  In short people give twice the weight to the pain of lossthan they do to the pleasure of gain. We are therefore risk averse in the realms of losses, but risk prone in the realm of gains: almost the opposite of what most people suspect. We are in a time of serious and significant loss of value: which stimulates emotionality over rationality. Focus on the big picture, the broader whole, the wider issues; forget the past because you are not there to justify earlier behaviours; reframe losses as gains, like lessons learned.
  2. Sunk cost is the situation of throwing good money after bad; of continuing on a loss-making project to “justify” the amount of money already spent on it. All that time, effort, and money “gone up in smoke; down the drain” Most investors have to put a great deal of effort into getting the data upon which to make good decisions and “sunk it” with money into their choices. This can mean being very reluctant to let things go, for example selling weak stock when one should. We are in a different world; things have changed. Like the gambler who walks into the casino saying, “I have come to get my money back”, it takes a realist to face up to losses.
  3.  Endowment This is the idea that people have the tendency to overvalue things they own. We place a higher value on things that we personally possess (shares, for example) than their actual, sometimes even printed, market value. Such people overvalue what they have: they endow it with psychological wealth and are misguided about its actual worth. This can lead them to being very disappointed when coming to sell them. Indeed, some shares they own are actually pretty worthless.
  4. Peak-end-rule – this is about thinking about the value of investment in the good times (peak) and continuing current value (end). The evaluations we keep in mind of previous experiences are based on the peak of either how pleasant or how unpleasant they were, and how the event was perceived at its end. Events are not evaluated rationally, considering how pleasant the experience was on average. Here, information that occurs at the beginning and the end is better recalled than the information that occurs “in the middle”. Over-estimating how good things were a year or two ago is as dangerous in believing how grim things are now. Both lead to bad decisions.

There are many other biases and heuristics that always occur and are nor particularly active in volatile times. These include:

  1. Availability. This bias is based on the notion that if you can (quickly and easily) think of something, it will be rated as very important, more important than if the issue is more difficult or less easily available to imagine. The more often an event occurs, the more mentally available this is for retrieval – and this factor is used to estimate likelihood of occurrence. The trouble is that the frequency with which particular events come to mind is usually not an accurate reflection of their actual probability in real life. This short cut also leads to illusory correlations where, because people can relatively easily recall events that occurred at much the same time, it was believed that they were related to each other.
  2. Fluency This is a simple heuristic, suggesting that we prefer information that is processed with ease. Those things (ideas, objects, theories) which are processed faster, more easily and more smoothly appear to have higher value. Simple, straight-forward things seem more important than they are because they are more understandable. Researchers found that stocks with fluent and easily pronounceable names outperformed non-fluently named stocks. The authors based this finding on fluency, and that fluently named stocks are considered to be more valuable due to the ease with which they are processed.

The savvy adviser will by now have heard of Behavioural Finance. It should help them understand their clients better. But most of all an appreciation of all the biases and traps recorded suggest that we are all prone to them. None are immune: but self-awareness is the best defence.

Professor Adrian Furnham is principal adviser and Steve Braudo  is managing director at Stamford Associates

CPD
Approx.30min

Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

  1. The basic assumption of behavioural finance is that we are as rational as we think we are, true or false?

  2. What can happen if someone gets a "run of good luck" in the markets?

  3. It is not good practice to follow the crowd, when considering investments, true or false?

  4. Why do past experience and habits need to be given up?

  5. We take more risk to avoid losses than we do to achieve gains, true or false?

  6. What is the availability bias?

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  • Describe what behavioural finance is
  • Explain some of the biases that creep into investor behaviour
  • Identify some of the dangers that come with behavioural biases

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