Human biases
This deviation from what can be expected of a rational human being is due to errors in our intuition which, in turn, are caused by psychological and emotional biases that all human beings suffer from without exception, and which are the result of people’s natural cognitive limitations (for example, in terms of calculation and memory) and the influence exerted by emotions.
So, no matter how much education, training and experience you have, or how much of an expert you are in the field, you will always suffer from these biases. However, the good thing is that although you can’t eliminate them, you can mitigate them.
That’s why, in order to be a successful investor and maximise your returns, it’s important to be aware of the biases that can lead you to bad financial decisions. So, without further ado, let’s get down to business: what psychological and emotional biases are and how they affect your financial decisions and, consequently, the returns on your investments.
Overconfidence
Firstly, and most importantly, it leads them to believe that they are better at trading on the market than other investors. Consequently, people with more confidence in themselves trade more often, which means that in the end they bear more transaction costs and see part of their returns “swallowed up” by these costs.
It is therefore possible that, compared to less confident investors, they perform worse. In fact, there are empirical studies that prove that men are more confident than women and, as a result, tend to produce worse financial results.
Secondly, more confident investors tend to believe that they have an advantage over others in terms of information. They therefore believe that the “private” information they are able to gather is somehow better than the information that is publicly available.
It is for this very reason that an investor often ignores other information that contradicts their own expectations and therefore spends too much time and money looking for specific financial information.
Thirdly, overconfidence leads investors to build poorly diversified portfolios and to trade in riskier assets.
While having confidence in yourself can be a good trait, overconfidence can lead you down bad paths.
Representativeness
Representativeness is a bias that induces people to assess the likelihood of a certain event by considering the degree of similarity of that event with the information and data they have available and is manifested above all by the need to categorise the characteristics of that event.
In your day-to-day life, you’ve probably noticed that you tend to associate a man in a suit with a businessman, a tall, blonde, blue-eyed girl with German nationality or the Nordic countries, or, as mentioned in the first article, a tall, athletic boy with a basketball player. These associations are simply the result of a psychological bias in human beings. We find it easier to organise and process information if everything is in its proper place.
In your financial decisions, representativeness is responsible for making you extrapolate price trends (when they don’t exist) and, together with overconfidence and similar behaviour from other investors, it can create a speculative bubble.
Thus, when you buy a share and subsequently see its price rise, you tend to feel that “it was a good buy” and that the most reasonable thing to do is to buy even more. Further price rises will reinforce the confirmation of your opinion, leading you to incorrectly extrapolate a growing trend and strengthen your position. Ultimately, this behaviour could lead to rapid price inflation.
Equally important is the effect of representativeness on their tendency to associate solid companies with good investments, and also on their perception of the relationship between risk and return. Individuals’ intuition is to associate higher returns with companies that are well established in the market, i.e. low-risk companies, and therefore the perception is of a negative correlation between risk and return. However, their correlation is positive.
Anchoring
Initially, when someone wants to estimate a certain value or probability, there is a tendency to attach too much importance to a certain piece of information and/or initial value, the so-called “anchor”.
After considering this first point of reference, the individual successively adjusts their expectations according to the additional information. However, these adjustments turn out to be insufficient and so, in the end, the estimate is too biased towards the initial expectations.
For example, if you see two shirts on sale in a shop, one for 1,000 euros and the other for 100 euros, you will tend to say that the second one is cheap. However, if you hadn’t seen the first shirt, you would consider the second one to be expensive too.
Another example (this one more related to the financial world) is: if I ask you what your estimate is for the price of Microsoft shares ($MSFT) in 6 months’ time, your first instinct is probably to think about what their price is at the moment, and only then estimate based on that value.
The consequence of this bias in your financial decisions is that you don’t adjust your expectations enough when estimating market developments. Thus, in their thinking, they tend to overweight current market conditions and information (such as the price) in favour of information that might contradict their “anchor” (and is therefore information that is ignored).
In addition to the current price, people use the opinions of financial analysts, the 52-week high and round numbers such as 20,000 or 30,000 as an anchor).
Availability
Not all of our memories, learnings, moments and experiences are equally available in our brains. I think you’ll agree with me when I say that we remember little about our primary school days, but we remember well what we had for dinner last night. Or when I say that we’ll never forget that Portugal won the 2016 European Championship, but we forget who the winners were in previous editions.
This is simply the manifestation of the effect of a psychological bias that leads us to attach greater importance to information that is more cognitively accessible, in other words, information that we can remember more easily and quickly.
The information that is easiest to remember is that which is most recent, most prominent (for example, if it’s a news item), most shocking and/or with which we connect emotionally. Thus, if the reader has already been mugged or had a violent experience in Portugal, they will certainly tend to overestimate the likelihood of being mugged in this country and will also think the country is less safe than it really is (even though Portugal is one of the safest countries in the world).
In terms of financial decisions, human beings tend to invest in companies whose names are easier to process and remember and that follow their life experiences, i.e. companies that are part of the sector in which they work or companies based in the area where they live.
In addition, too much weight is given to recommendations from financial analysts, suggestions from friends or information from the news. With regard to the latter, studies show that investors tend to buy shares on the same day that there is news about them.
Finally, the most recent prices are more relevant than older prices, which leads humans to over-extrapolate price trends.
Self-attribution
Naturally, people attribute the achievements and successes of their lives to their own merit, talent and effort, while failures are attributed to an external factor such as bad luck.
For example, when we get a 20 in a test, we say that it was the result of hours of studying. However, in the opposite situation, when we get a less favourable grade, we say it was the teacher’s fault because the test was too difficult.
Leaving the academic world and returning to the financial one, self-attribution causes investors to trade excessively in the market and not learn from their mistakes, sometimes taking high-risk positions.
Hindsight
When a certain event occurs, human beings tend to believe afterwards that this event was quite predictable in the past. Thus, before it happened, it was already expected that the event would occur.
To clarify, an example of this bias would be me, right now, saying that I already knew that, after Bitcoin ($BTC) reached the price of 63,000 dollars, the cryptocurrency was going to fall. Of course, this statement is false; we all know that it’s very difficult to predict a market, especially one as volatile as the cryptocurrency market.
This bias arises from the simple fact that, after the event has already taken place, people can’t imagine another scenario where they wouldn’t have the information they currently have.
Therefore, this particular bias can be very dangerous for your financial decisions. In fact, if you believe that you were able to predict the past better than you did, then, by logic, you also believe that you can predict the future better than you actually will.
Consequently, like self-attribution, this bias impairs investor learning in the financial markets and leads investors to take high-risk positions. It also leads investors to think that they can make better decisions than financial analysts and fund managers when they fail in their forecasts.
Thus, there is no point in believing that you were able to predict past events and that you have the power to do so in the future. Your only use is to argue in a discussion between friends.
Mental accounting
This bias is another argument that goes completely against what is expected by traditional finance. According to modern portfolio theory, developed by Markowitz, people should manage their portfolio as a whole, i.e. manage their assets together.
In reality, however, this is not the case. In fact, there is a human tendency to organise and categorise facts and events, and to evaluate economic results in various “mental accounts”, which are managed in isolation.
Therefore, these “mental accounts” are naturally divided into two large groups:
assets for which investors are risk averse;
the assets for which investors are risk-prone;
This division is completely logical and makes a lot of sense if we think about certain cases that occur in reality. In fact, we are much more likely to gamble money that we won in a game between friends or that we found on the street, but we protect the money that comes from our salary, because the latter was received due to our effort and sweat.
Another example is the use of a credit card or money in a savings account. Which are you more willing to use to buy the latest version of the iPhone? Of course, your answer will tend towards the first option. Mind you, in economic terms, it’s the same.
Professionally, it’s also this kind of bias that leads financial institutions to separate accounts that manage shares and bonds from investment accounts in the foreign exchange market.
Other effects of this bias on your financial decisions are inadequate risk diversification – as you don’t look at your portfolio as a whole and therefore don’t have a perspective on the correlations between assets. People are reluctant to close positions that are losing as long as they belong to the same mental account and, finally, people undervalue gains and losses until capital gains or losses are realised.
Aversion to regret
I think you’ll agree with me when I say that regret is a very strong emotional pain associated with the feeling of wanting to go back in time and not make a certain decision. In fact, human beings always try to make decisions in order to avoid this pain, which is associated with unfavourable results in our lives.
This bias is responsible for what is known as herding behaviour, an effect that makes us imitate the behaviour of other human beings. This is because when we make the same mistake as other people, the pain of regret is no longer so intense. Of course, I won’t feel as much regret if other people have thought and acted in the same way, so it’s better for me to simply follow the actions of others.
What’s more, it’s responsible for the “disposition effect”, where we feel reluctant to sell a falling share so that we don’t admit we’ve made a mistake (so that, deep down, we don’t feel regret).
Cognitive dissonance
Cognitive dissonance is responsible for our brains sometimes clashing. This bias happens because we have contradictory ideas in our heads at the same time.
More explicitly, this phenomenon occurs when we have pre-existing ideas (which have been formulated by past information and our life experiences) and we receive some kind of new information that goes against what we had pre-established. Clearly, the two pieces of information will clash and create a certain tension in us.
From this conflict, two paths can be taken by the individual in the decision-making process:
there may be a tendency to process only the information that corroborates the point of view that will henceforth be defended by the individual, ignoring everything else;
certain actions may be taken that allow the individual to continue following their initial point of view, even though it may be wrong;
The most direct consequence of this bias is the aforementioned “disposition effect”.
Conservatism
This is a mental process in which people tend to cling to the information they have, their opinions and expectations, attaching excessive importance to them at the expense of new information, which should also be incorporated.
In this way, human beings fail to analyse new information and do so too slowly and incompletely. The direct consequence of this is the slow reaction of prices to new information. Sometimes you have to be FOMO!
In your personal finances, conservatism can lead you to be too reluctant and slow to rebalance your portfolio in the face of new circumstances or new information, and, like the other biases mentioned above, it can lead you to have a certain inertia in realising capital losses.
Confirmation
In a nutshell, confirmation bias is the tendency of human beings to search for, interpret and/or select from their memory only that information which allows them to confirm their previous beliefs, while ignoring that which contradicts them.
However, it is obvious that, in terms of investment decisions, looking only at the information that is of interest to you is refusing to take a view of the market in general and ends up making your opinion biased. And, of course, this is a threat to your money and leads you to make the wrong decisions.
Familiarity and Home bias
Let me explain further what I want to make clear with these analogies. In financial terms, familiarity bias is the tendency for people to exhibit a preference for investing in assets that are more familiar to them.
Consequently, home bias is exhibited by the preference that investors have for companies that are correlated with their nationality, such as companies listed on the stock exchange or based in their country and which have a culture similar to that of the investor.
A study carried out on the Finnish market showed that Finns are more likely to invest in Finnish companies whose CEO shares the same culture, whose financial reports are written in their mother tongue, and which are geographically close.
The immediate effects of these two biases are over-investment in assets that are familiar, which ultimately produces insufficient portfolio diversification, whether in terms of asset classes, geographical location, diversity of cultures or financial markets.
Conclusion
To date, I would say that these psychological and emotional biases that I have presented throughout this article are the main and most relevant to your financial decisions. It is certain that many others will be discovered, given the recent development of this new area of behavioural finance and the valuable knowledge in the field of psychology.
This is how the importance of the development of this new area stands out, by showing us how factors in the nature of human beings affect our financial decisions and, consequently, allow us to question the efficiency of the financial markets. But this is a subject for a later article.
By this point in the article, the reader is probably feeling astonished and, to some extent, discouraged at having identified with some of the behaviours described above. However, don’t worry because, after all, we all suffer from the same symptoms.
The Web Economist 