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BEWARE of your Biases

March 1, 2024
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FinMeUp
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FinMeUp

A look at behavioural finance and its influence on investors.

Behavioural finance studies the influence of psychology on investor behaviour. It challenges the study of traditional finance, where investors are believed to be rational, have self-control, and act without bias.

Some of the most common behavioural biases include loss aversion, anchoring, overconfidence, self-attribution, cognitive dissonance, hindsight, herding, and framing. This article will investigate the abovementioned biases and aims to develop tools to guard ourselves against them.

 

Loss aversion
Research show that humans experience the pain of a loss more than twice as strong as the joy of a gain. This leads to investors often holding onto losing investments for much longer than they should, thereby suffering bigger losses than necessary. The loss doesnt count until the investment is closed. 

To counter loss aversion, we can set up pre-commitments to future outcomes. The stock price is currently R100. I believe it will increase to R130. If it falls to R80, I will accept the loss and exit the position.

 

Anchoring
Anchoring bias is the reason why first impressions are so important. It occurs when our decisions are influenced by a particular reference point or anchor. Once the value of the anchor is set, subsequent arguments and estimates are derived from this reference point, forcing us into subjective, inaccurate judgements. 

For example, if you first see a T-shirt that costs R800 then see a second one that costs R300 youre prone to see the second shirt as cheap. Whereas, if youd merely seen the second shirt, priced at R300, youd probably consider it as overpriced. The anchor the price that you saw first unduly influenced your opinion. 

we can counter anchoring bias by always conducting objective analysis. Trust your own due diligence, and then look to what others are saying. 

 

Overconfidence & Self-attribution
Overconfidence bias is the tendency to overestimate our skills, intellect, or talent. In short, its a belief that were better than we actually are. Overconfidence tends to make us less cautious when making decisions. 

Self-attribution bias stems from the need to maintain and enhance self-esteem. It is the tendency of investors to attribute their success to talent and skill but blame their failures on situations beyond their control. Remember, everyone is a genius in a bull market. Self-attribution leads to unwarranted arrogance and causes investors to fail to learn from past errors. 

To counter overconfidence and self-attribution, its important to stay level-headed, grounded, and self-aware. Keep evaluating and keep surrounding yourself with people who are more knowledgeable than you. 

 

Cognitive dissonance & Confirmation bias
Cognitive bias goes together with confirmation bias. It is the tendency of people to pay close attention to information that confirms their beliefs and ignore information that contradicts it. We have a natural tendency to listen to people who agree with us we just love to hear our opinions reflected back to us. 

To avoid these biases, it is important to apply careful risk management practices. We must always play devils advocate when it comes to our own decisions. What is the best counter-argument for my thesis, or What is the worst-case scenario should I invest in this stock.


Hindsight
Hindsight bias is the misconception that, after the fact, one always knew the outcome of an event before it happened. We often hear people say: I could have made so much money if only. followed by an array of reasons why the individual never invested their money in the first place. 
The best way to deal with hindsight is to assess every opportunity as fair and objective as possible, and then be content with the result, whichever way it goes. Its impossible to spot every golden nugget or invest in every moon-shot.

 

Herding
Herd mentality is the tendency to follow and copy what other people are doing. Herding bias is deeply rooted in our evolution, but when it comes to business and investments, we must stay level-headed and always challenge the status quo. Ask yourself: Am I making this decision because I truly believe in it, or am I doing it because everybody else is doing it

 

Framing
Framing bias occurs when we make decisions based on the way that information is presented. Lets evaluate how the revenue growth of company ABC is framed:

Option 1: In Q2, our revenue growth was 8%, compared to expectations of 10%.
Option 2: In Q2, our revenue growth was 8%, compared to 3% in Q1.

Option 2 does a much better job of framing the earnings report. The way it is presented as an improvement instead of a below-expected result - puts a positive spin on the metric.

Of course, companies will always display results in the best way possible. Knowing this, we must challenge ourselves to view outcomes in a logical, objective manner instead of chasing shiny rocks.


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