How behavioural bias skews investment decisions

Behavioural bias is a major barrier to good investment decisions. Part of the reason for this is that it’s often overlooked, seemingly immune from the scrutiny that accompanies other aspects of investment thinking.

Today, I’ll examine some of the common biases that can distort investor thinking. In a future blog, I’ll take a look at how biases can affect investment thinking in broker research.

Confirmation bias: beware the echo chamber

It would be wrong to say I’m not affected by behavioural bias, but experience has taught me to make conscious decisions to combat it.

‘Confirmation bias’ – the tendency to ascribe the most weight to evidence that supports our existing views – can lead investors to ignore highly relevant information because it doesn’t fit their thinking.

I’ve found that if we change our routine, this can avoid the echo chamber effect; this could be as simple as seeking out bearish views on markets in which you have a bullish stance. Contrarian views are valuable, while consensus views should always be seen as a potential red flag.

Recency bias: think long term

‘Recency bias’ results in undue focus on recent events over longer-term outcomes.

The optimal time to invest in something is often immediately after a significant decline, for instance emerging market debt in 2022 following the rising of geopolitical tensions. However, this is difficult to do in practice because there is a strong mental association between negative recent events and the investment area in question.

Recency bias also affects overall perception of investment risk, sometimes leading investors to liquidate their exposures at the worst possible time. In 2008 global markets saw record falls, leading many investors to sell. In many cases, investors who held their nerve until the end of 2009 realised big profits as markets recovered. We saw a similar dynamic more recently following the outbreak of COVID-19.

Loss aversion: put losses in perspective

Given the choice of being handed a crisp £50 note or being given two £50 notes and then told you must return one, most people chose the first option, even though the outcome is the same.

‘Loss aversion theory’ explains this behaviour with the idea that losses cause a greater emotional impact than gains.

Today, risk aversion is magnified by wider access to information – the more frequently you look at your portfolio, the more you may focus on the risks. This specific issue is called ‘myopic risk aversion’, and results in too much weight being given to events in isolation, rather than recognition that over 100s or 1000s of days the risks to the overall outcome are much lower.

Egocentric bias: learn from your mistakes

This is something I regularly come up against. Clients are keen to talk about their investment wins, but not their losses.

This makes my job harder, as I want to add value and discuss areas that haven’t performed well and offer alternatives. If we embrace mistakes as investors, we’re much more likely to be able to learn from and approach future investment decisions accordingly.

In-group bias: keep your options open

Analysis of this bias dates to 1906, when sociologist William Sumner wrote that “each group nourishes its own pride and vanity, boasts itself superior, exists in its own divinities, and looks with contempt on outsiders”.¹ In essence, in-group bias leads individuals to favour views from their own group over views that are perceived as being out of group.

In the investment world, I believe this bias can help explain the heated, and sometimes almost tribal, debate around ‘active’ and ‘passive’ strategies. Thankfully, many are aware the investment world has evolved, and prefer the term ‘index’ to passive as it better reflects the ability to create indices that are not mainstream and have the ability to exclude sectors or stocks.

However, some investors still put themselves firmly in either the active or the passive camp, and won’t change their views, regardless of evidence showing how the two approaches can complement each other.

I think it’s fair to say that no one can avoid all behavioural biases, but if we are aware of them we can hopefully be more open minded. As Einstein once said, “The measure of intelligence is the ability to change.”

1. Source: Folkways: a study of the sociological importance of usages, manners, customs, mores, and morals, p13