Behavioral Biases of Investors

Traditional finance assumes investors are rational. A rational investor consistently makes the correct investment decision based on information and expected utility. This framework is the basis for the efficient market theories as well as many other investment models. However, behavioral finance is a more modern approach that assumes investors and decision makers are not fully rational. The behavioral finance model aims to explain why there are large deviations from the fundamental value of a stock. There are several behavioral biases that have been identified in studies of investors that can assist in explaining price divergences from fundamental values. Psychology literature has been applied in a financial context to provide evidence of these biases.

The first bias I will discuss is overconfidence. This is where investors have an irrationally high opinion of their ability and the accuracy of the information available to them. More importantly, the bias can be further exemplified by investors ignoring errors or failures thereby creating an illusion of success. Overconfidence can manifest itself with all levels of investors, from individual investors to professional money managers. For individual investors, you will see a tendency to put too much weight on information they perceive to be proprietary. In other words, there is a belief that you know more than the next guy about a particular stock. Professional investors can be subject to overconfidence in slightly different ways. It is not rare to see the pros underestimate the risk of an investment due to confidence in their investment strategy. An investment can fit their criteria but still hold risks that they are discounting due to their belief in their own system.

With overconfidence, you also get a self-attribution bias where investors take credit for the good decisions and pass blame when outcomes are negative. These are typically referred to as the self-enhancing and self-protective biases. As discussed previously, the consequences of overconfidence and self-attribution bias include underestimating risk, overestimating returns, trade too much (have an illusion of control) and then end up experiencing lower returns than the market. Some of the ways to combat an emotional bias like overconfidence are to seek out multiple different opinions and to conduct fundamental analysis. By seeking non-conforming opinions, you will gain a healthy pessimism for your own beliefs that were previously deemed correct. Conducting fundamental analysis of an investment will enable you to carefully examine the truthfulness of your opinions and provide number values that you can base the decision on. Although numbers can also be altered, that can be a positive as you can then input different scenarios to see what your investments may look like down the road.

Another important bias I would like to point out is the regret aversion bias. In the investment context, this refers to peoples avoidance of making investment decisions because of their fear of a negative outcome. It consists of two types of fears, the error of commission and the error of omission. Error of commission is the fear of taking an action while omission is the fear from not taking an action. It is typical that investors have greater regret if they make a decision and the outcome is not favorable. Therefore, there is more fear of commission over omission. The result of this bias leads to investors being too conservative choosing investments because they are scared of being wrong about their choice. It also lends itself to the idea that most investors follow the herd. The herding behavior basically means that everyone follows what everyone else is doing because they would have more regret if they strayed from the herd and were incorrect.

To overcome regret aversion, investors must realize that losses are part of the process and maintain sight of the long-term benefits of the investment. I find it best to recognize that these biases do exist and do your best to make carefully planned decisions for the long term. It is almost impossible to resist the urge of going with the herd especially during a recession type period like we are currently experiencing. Maintaining that long term view while adjusting for new information is much easier said than done. Knowing that there are all these biases that go along with the difficulty of investing is an important concept to take note of and make part of the due diligence process.