Investor Discussions - Investor Biases
Wealth & Pension Services Group
Matt B. Bailey, CFA, CMT - Senior Portfolio Manager
04/19/16
What do the CIA and Investors Have in Common?
Over the last few decades, significant research has been conducted on how cognitive biases can negatively impact investors. Studies by psychologists such as Nobel Prize winner Daniel Kahneman have been used by investment researchers to highlight the importance of recognizing cognitive biases when making investment decisions. Many biases appear simple and easily avoidable; however, the studies have shown that significant mental effort is required to prevent them from occurring.
The CIA (yes, the Central Intelligence Agency) defines cognitive biases as, “…mental errors caused by our simplified information processing strategies… a cognitive bias does not result from any emotional or intellectual predisposition toward a certain judgment, but rather from subconscious mental procedures for processing information. A cognitive bias is a mental error that is consistent and predictable.”
Interestingly enough, researchers found that even the most qualified investment professionals exhibit basic behavioral biases. Some of these experts include money managers, analysts, and economists. Unfortunately, they also uncovered that these biases can have a profound negative effect on investment returns.”
Within our firm’s investment process, we attempt to identify and correct behavioral biases when making investment decisions. Below, we’ve outlined five biases investors tend to exhibit and should seek to avoid. Additionally, we’ve provided real life examples and simple solutions to minimize their impact.”
1. Bandwagon Effect
- Definition - believing or doing something because others around you believe or do it
- Example - price momentum (positive and negative); creation of price bubbles (e.g. tech bubble)
- Solution - do your homework; does the investment make sense or are you following the herd?
- Definition - overestimating the importance of easily recalled or confirming information
- Example - remembering only what you understand or info that confirms your existing beliefs
- Solution - double check the “facts” with hard data and statistics
- Definition - seeking and prioritizing info that confirms your existing beliefs
- Example - gravitating toward validating info and avoiding conflicting views
- Solution - seek out contradictory research and opinions; question your investment thesis
- Definition - believing you could’ve predicted an event after it has occurred
- Example - everyone sees the obvious top, bottom, or idea after the fact but rarely do in real-time
- Solution - evaluate the current environment and attempt to figure out what you might be missing
- Definition - excessively focusing on the first piece of info received when making a decision
- Example - investors can unknowingly stay glued to initial price targets or price levels and fail to update
- Solution - be willing to change your forecast or views as market conditions change
These biases are constantly prevalent and fighting to get attention in our subconscious. Not just when we invest, but in everyday life as well. Being more aware of them may help you make better decisions and feel better about the decisions you do make.
As always, please feel free to contact us with any questions you may have.
William Kring, CFP®, AIF®
Chief Investment Officer
Matt B. Bailey, CFA®, CMT®
Senior Portfolio Manager