Editor’s note: This article was first published in June 2014; the SlideShare presentation it features is from a 2013 conference, and Rafael Romero’s job title at Unicorp Patrimonio, Unicaja’s private banking arm, is as of 2014.
First of all, there are many people we should credit and thank for the content of this comprehensive article and invaluable course on the behavioral biases investors fall victim to without even knowing it. As you know, we’ve been writing for some time about all the kinds of biases that affect us in life, in business and in investing.
I was preparing this article when I saw that @EzraCrangle, who runs the site The Tax Havens, had shared a SlideShare presentation on his Twitter account (it’s linked at the end of this article). That led me to a summary of exactly what I was looking for to put together this short course on an aspect of the stock market that isn’t always covered, and that may matter more than other market topics that usually get more attention.
1. The investor’s 15 behavioral biases
Welzia Investment sums up perfectly why investors lose money in the stock market and make bad decisions. It starts from the premise that people aren’t rational and markets aren’t efficient. That is the landscape in which investors have to look for returns, and increasingly they need to turn to what is known as behavioral finance. Only then can investors find their footing on the stock market’s quicksand.
In Welzia’s report, published by FundsPeople, the two types of behavioral bias are explained: cognitive errors (the result of faulty cognitive reasoning) and emotional biases (decisions made with reasoning influenced by feelings and emotions). Even so, when it comes to investing in the stock market, cognitive errors are much easier to eliminate than emotional biases.
Cognitive errors: belief perseverance
The tendency to cling to prior beliefs in an irrational or illogical way.
| Bias | Definition | Risks | Welzia’s recommendation |
|---|---|---|---|
| Conservatism | Giving more weight to the information we received first | Making poor decisions. Not making the investment | Ask a professional for advice |
| Confirmation | Seeking out and overweighting information that confirms our beliefs, and dismissing and underweighting information that contradicts them | Holding an underdiversified portfolio with excessive risk | Look for new information that contradicts our beliefs. Get help from someone qualified who can analyze whether the investment suits the investor’s needs |
| Representativeness | Classifying new information on the basis of past experiences and classifications, even when they are actually unrelated | Giving too much weight to the newest information. Excessive portfolio turnover. Making decisions based on superficial classifications | Learn more about the laws of probability and statistical analysis |
| Illusion of control | Believing you can control the results of an investment when in reality you can’t | Trading more than necessary. Not diversifying portfolios enough | Remember the rules of probability. Map out different scenarios. Periodically re-evaluate your investment ideas to see whether they were right |
| Hindsight | Selective memory of past events. Remembering the hits and forgetting the misses. Believing that past events were easy to predict | Overestimating the hit rate of your predictions and being overly critical of decisions made by others | Periodically re-evaluate your investment ideas to see whether they were right |
Cognitive errors: information processing
These relate to how information is processed and used when making investment decisions.
| Bias | Definition | Risks | Welzia’s recommendation |
|---|---|---|---|
| Anchoring and adjustment | Estimating the probability of an event on the basis of the simplest examples that come to mind | Anchoring on a value and later trying to adjust it up or down as new information is processed, when that information should be considered objectively | Ask yourself: “Does my decision depend on that earlier price?” or “Would I recommend this investment based on the new information I’ve received?” |
| Mental accounting | Treating money differently depending on how it is categorized | Building a portfolio in separate layers according to the goal of each one. Ignoring the correlation between the different assets in the portfolio. Being reluctant to add new assets uncorrelated with the current portfolio, even if they would reduce its risk | Avoid putting too much emphasis on income-generating assets, as that would produce a lower overall return |
| Framing | Answering a question differently depending on how it is asked | Building portfolios that are too risk-averse or, on the contrary, portfolios that carry more risk than desired | Think in terms of absolute return rather than in terms of gains and losses |
| Availability | Considering events that come to mind more easily to be more likely than those that don’t, or that we don’t fully understand | Choosing an investment, a manager or a fund because it is well known through advertising. Limiting the investment universe to domestic assets. Holding portfolios without enough diversification. Failing to reach an optimal asset allocation | Draw up the investment policy statement methodically and focus on the long term |
Emotional biases
Unlike the previous ones, these arise from emotions and feelings rather than from conscious thought.
| Bias | Definition | Risks | Welzia’s recommendation |
|---|---|---|---|
| Loss aversion | Feeling more pain from a loss than pleasure from a gain of the same size | After a small initial loss in value, taking on more risk in the hope of recovering it | Focus on long-term appreciation prospects. Attach less importance to current gains or losses |
| Overconfidence | Showing unjustified confidence in your own opinions. Overestimating your own knowledge, skills or access to information | Underestimating risk. Holding poorly diversified portfolios and trading too much | Always keep in mind the investment policy statement and the strategic (long-term) asset allocation |
| Self-control | Sacrificing long-term goals because of insufficient self-discipline | Not saving enough for retirement and therefore taking on excessive investment risk to try to make up for the lack of past saving | Study your future liquidity needs. Set aside every month the amounts needed for the long-term investment. Draw up a plan to reach the goal |
| Status quo | Doing nothing. Building a portfolio and never reviewing it again, even when your capacity to take risk has changed or your liquidity needs have increased | Not considering other, more attractive investment options | Have an adviser explain everything about the risk–return trade-off |
| Endowment | Valuing investments differently depending on whether we want to buy or sell them | Clinging to a familiar stock because of the intangible sense of comfort it provides | — |
| Regret aversion | Avoiding decisions for fear of getting them wrong. There are two kinds of regret: for actions taken and for actions not taken | Being too conservative with investments and therefore not achieving the desired return. Following “fashionable” investments | Emphasize the benefits of diversification and the negative effects of not reaching long-term goals |
Source: FundsPeople/Welzia Management
Now that we’ve seen these biases, let’s move on to the SlideShare presentation, which explains behavioral finance graphically and visually, along with the psychological biases that affect investor behavior.
This presentation was used at a stock market conference at the University of Málaga in 2013. It was given by Rafael Romero, Chief Investment Officer at Unicorp Patrimonio (Unicaja’s private banking arm) and author of the Negoestrategia blog.
See: Finanzas Conductuales: Sesgos Psicológicos en el comportamiento del inversor (Behavioral finance: psychological biases in investor behavior, in Spanish), by Rafael Romero Moreno
I hope I haven’t left out anyone involved in this content.
Further reading
- The mother of all stock market investing mistakes
- Why does the stock market always end up falling?
- Jesse Livermore: probably the greatest speculator of all time
Featured image: unknown author, Public domain, via Wikimedia Commons.
