Hello Friends!
This week we're exploring a huge topic that isn't discussed often enough: How biases and heuristics impact investor behavior.
Quick Definitions
Before jumping into the biases and how they impact investing, we first need to cover what biases and heuristics are.
Bias
A bias is an unconscious error that impacts our thinking & judgement.
Heuristic
A heuristic is a mental shortcut that simplifies problem-solving & decision making.
It's important to note that everyone is biased in some way, and everyone uses heuristics as part of daily life.
Being aware of them when it's time to make important decisions will only help improve our decision-making process.
The Biases & Heuristics
Overconfidence Bias
This occurs when investors overestimate their knowledge, underestimate risks, and
exaggerate their ability to control events.
It often leads to aggressive trading and underestimation of potential losses.
Confirmation Bias
This occurs when investors seek out information that confirms existing beliefs and ignore or discount information that contradicts existing beliefs.
It can lead to overconfidence in certain investments without a balanced view of risks.
Anchoring Bias
This occurs when Investors rely too heavily on an initial piece of information (the "anchor") when making decisions.
For example, an investor might "anchor" to the purchase price of a stock, impacting the decision to buy or sell as the price changes.
Loss Aversion
Loss aversion is the fact that people feel the pain of loss (and fear loss) more than the pleasure of gaining.
Studies show the pain and fear of loss is 2x the feeling of pleasure from gaining something.
Because of this, people tent to avoid making painful-feeling decisions because they feel they're losing something.
An example: selling a stock out of fear the price may rebound, or that it may continue to rise.
Herd Mentality
This may be the bias most have heard of before. It leads investors to follow along or mimic what they perceive others are doing rather than making independent decisions.
It can contribute to asset bubbles and crashes. A more recent example may be the crypto craze of a few years ago. While not all crypto is created equal and some have useful applications, the hype and craze around "meme coins" is a great example of herd mentality.
Recency Bias
Investors tend to overemphasize recent events over historical data, leading them to make decisions based on short-term trends rather than long-term fundamentals.
The crypto craze is a great recent example. In the moment, it looked and felt like crypto would only continue to rise. Backing up a little, it was obvious it would eventually go through a "correction" because while the technology was certainly novel, it's real-world use cases weren't profitable to justify the astronomic prices.
Mental Accounting
This is when we treat money differently depending on its source or intended use, such as gambling with "house" money.
Another example is setting aside "birthday money" for something other than what we should do with it because it was a gift.
Not having clear financial goals makes mental accounting is easier to fall into. What's more is the frustration felt by using the funds for something other than what we mentally assigned it to can invoke loss aversion, which we discussed earlier.
Ultimately, it can lead to sub-optimal allocation of resources or compound cash management challenges.
Familiarity Bias
This is when investors prefer investments they are familiar with over unfamiliar ones, even if the unfamiliar options are a better investment.
Common examples are doctors choosing to invest heavily in healthcare equipment companies they work with on a daily basis, or choosing to invest in a specific car manufacturer because you own one of their vehicles.
The result can be holding a poor performing asset, high concentration in a particular industry, or lack of overall diversification.
Disposition Effect
This is the tendency to sell assets that have increased in value but hold onto assets that have decreased in value.
Related to loss aversion and can hinder portfolio performance.
Home Bias
This is when investors demonstrate a preference for domestic investments over foreign ones, which can limit diversification and exposure to potentially higher growth opportunities abroad.
BONUS:
Snake-Bit Effect
For investors, this occurs when we experience losses and become more conservative/risk-averse as a result, even to the extent of not wanting to invest in the same company or industry again.
All in all, everyone is influenced by biases and heuristics.
The trick is identifying which ones are influencing us so we can learn to work with them and make better investment decisions.
Have a great week!
27 February 2024
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