Research over the last couple of decades has shown that as much as the finance system assumes that we, as individual investors, are rational, the reality is we are certainly not. The dotcom bubble and the global financial crisis certainly reinforce the fact.
A key consideration in this “irrationality” is the role of cognitive bias, described in Wikipedia as “a pattern of deviation in judgment, whereby inferences about other people and situations may be drawn in an illogical fashion”. To put it another way, these are certain pervasive thinking habits, which are likely to lead to errors in reasoning, but are a very common part of human psychology.
The better we are able to realise, understand and manage our biases, the easier it is to make informed decisions. In the realms of personal finance, there are a number of biases that it’s worth becoming aware:
Confirmation Bias: We tend to put more weight into the opinions of those who agree with us. This can manifest itself in you analyzing a stock, then later seeking out reports that support your thesis, instead of searching for information that may poke holes in your opinion.
Gamblers’ Fallacy: If you toss a coin five times in a row and each time it comes up heads, statistically speaking, there’s an equal chance of it being heads or tails in the sixth coin toss. Intuitively it may not “seem right” to us but that’s the truth. Similarly, if a market closed to the upside for five trading sessions in a row, on a purely statistical basis, the past events don’t connect to future events. There may be other reasons why the sixth day will produce a down market; but by itself, the fact that the market is up five consecutive days is irrelevant.
Status-Quo Bias: Humans are creatures of habit. Resistance to change spills over to investment portfolios through the act of repeatedly coming back to the same stocks and ETFs instead of researching new ideas. Although investing in companies you understand is a sound investment strategy, having a short list of go-to products might limit your profit potential.
Negativity Bias: Many investors miss bull market rallies because of the fear that it will reverse course. Negativity bias causes investors to put more weight on bad news than on good. At some point they may be right (“even a stopped clock is right twice a day”), but this bias can cause the effects of being too weighted to risk than the possibility of reward.
Bandwagon Effect: Dotcom bubble anyone? Investors feel better when they are investing along with the crowd. But as Warren Buffett has proven, an opposite mentality, after exhaustive research, may prove more profitable.
Loss-Aversion Bias: Investors often get emotionally attached to stocks, notably losers. Rather than sell and reinvest a loser, investors are often less willing to admit to the loss and will hold onto the stock in the sometimes distant hope of a recovery.
Overconfidence Bias: The whole industry is guilty of this. There are many bright people in finance but they can’t all be right all the time. Assuming “superior skill” and that the market has got it wrong can sometimes be a dangerous game.
Endowment Bias: Similar to loss aversion bias, this is the idea that what we do own is more valuable than what we do not. Remember that losing stock? Others in its sector may show more signs of health, but the investor won’t sell because he still believes, as before, it’s the best in its sector.
Money illusion: This is the tendency to concentrate on the face value of money rather than its value in terms of purchasing power.
The more aware you are of your bias in decision making, the better you will be with managing your personal finances.