It is the responsibility of the wealth manager to inhibit the biases that clients may have in order to preserve wealth and make data driven decisions. Biases can distort how an investor sees reality and can lead to making poor decisions that can cause serious damage to wealth and detract from achieving long term goals. However, wealth managers are human as well and can also have biases of their own. It is important to understand what biases are, and acknowledge them in order to avoid making the wrong choice. When searching for a wealth manager, the investor should be cognisant of these biases and understand when they are present.
A bias can be described as a preference or an inclination (especially one that inhibits impartial judgement) or an unfair act or policy stemming from prejudice(1). It is a distorted way of processing information that can lead the investor, or wealth manager, to make a decision that is not necessarily correct based on the reality of the situation. Biases in the investment world are categorized into two major types: cognitive biases and emotional biases. Cognitive biases are similar to processing errors that are common to human thinking, whereas emotional biases are similar to an emotional response based on past experience. There are 14 major cognitive biases and 6 major behavioural biases that are common to investing.
Major Cognitive Biases
Overconfidence.
The overconfidence bias is the unwarranted confidence in one’s own decision making or intuitive reasoning that has very little basis. A common example would be someone who thinks that they know something that the market does not and tries to exploit it. There are billions of dollars spent on research in equity markets, so it is very improbable that the average investor can out predict the market.
Representativeness.
The representativeness bias is the practice of clumping in information with similar (but not necessarily the same) information from past experiences. This will have investors mentally classify an investment opportunity with something in the past that does not have the exact same characteristics. IPOs are a common example, where an investor saw a previous IPO have massive success, so they will be inclined to invest in other IPOs and expect similar results despite the company’s being fundamentally different.
Anchoring and Adjustment.
The anchoring and adjustment bias is present when an investor is given information initially, and then processes new information using the previous information. An example would be if one were shown a hotel room and a price, and then another hotel room and asked to guess the price. It has been shown that the initial hotel room’s price has a significant impact on the guess of the second hotel room compared to no “anchor” being present. This is similar in the investment world when an investor is determining the intrinsic value of an investment after being anchored by another figure.
Cognitive Dissonance.
The cognitive dissonance bias comes from a state of discomfort due to new information not coinciding with past information. In general investors do not like being wrong, so they will try their best to avoid new information that disagrees with their past decision making. The discomfort from being wrong will cause anxiety and negativity within the investor, who will then act in a way to avoid the sensation. A common example would be that of smoking, people smoke despite the overwhelming evidence against it, and justify it by claiming that the negative effects are unlikely to happen to them. This is very present in active investing, where despite the overwhelming evidence that active investing on average underperforms the benchmark(2) they continue to try to time the market and expect to outperform on a consistent basis.
Availability.
The availability bias is when investors make estimates based primarily on how familiar they are with the information present. People typically fall back on the most prevalent example to make a decision, opposed to evaluating all possible information. Investors typically have short term memory, and will think that the most easily recalled information is best. An investment example would be if someone were to make a decision to invest conservatively due to the media’s negative representation of capital markets, opposed to investing in accordance with their risk tolerance.
Self-Attribution.
The self-attribution bias (also known as the self-serving bias) comes from attributing success to personal action and failure to outside events. This is a common bias for investors as many wish to believe that they are successful and will inherently forget bad decisions and remember the good ones. This is especially prevalent in active investing as many investors will attribute good decisions to “intuition” or a “hunch” opposed to pure luck.
Illusion of Control.
The illusion of control bias is self-explanatory, where investors believe that they have control of events that are outside of their realm of influence. This is commonly exhibited as superstition, like when a gambler blows on dice or throws them harder hoping for a higher result. The overestimation of personal influence can lead to frustration or unfounded positive reinforcement for investors who will assign blame to themselves when their actions had no effect on the situation.
Conservatism bias.
The conservatism bias comes from people avoiding information that contradicts their beliefs. This is responsible for the ignorance of new information and investors refusing to change their investment strategy despite evidence against their previous investment strategy. The under-reaction of investors to new information can be quite dangerous as investors could stick to a failing investment strategy despite early warning signs against it.
Ambiguity Aversion.
The ambiguity aversion bias comes from investors avoiding decisions or risk when the probability is unknown. A common example would be if someone were to bet on a ball being red or blue when pulled from a container. They would prefer to bet if the number of balls of each colour were known to be 50/50, opposed to if the distribution of balls were unknown. Investors will typically invest in an arena that they know, opposed to taking a chance and investing in a new area where the outcomes are not known. Older investors are typically known to exhibit this type of bias.
Mental Accounting
The mental accounting bias describes people’s tendency to categorize and evaluate economic outcomes by grouping assets into non-fungible (non-interchangeable) mental accounts(3). A common example of this is when a person receives a tax refund. The refund typically comes from too much tax being withheld from pay, so it has always been the person’s funds from the beginning. However, people will be more likely to spend their tax refund more recklessly opposed to if they had those funds saved up from before. Investors also exhibit mental accounting with “core and explore” strategies, where they hold a “safe” portfolio and invest speculatively with another portion opposed to investing in a unified investment strategy.
Confirmation.
The confirmation bias is a selective memory fault where investors will emphasize information that confirms their beliefs and degrade information that opposes them. This will cause investors to strengthen incorrect strategies while ignoring new information to the contrary, and over time have a significantly incorrect view on their situation. A common example is when a person believes a certain type of car is driven by bad drivers. They will always remark when they see a driver in that car do something wrong, whereas they will not remark when another type of car does something similar. This can be particularly dangerous long term as over time it can cause for a major distortion of the view of markets and wealth strategies.
Hindsight.
The hindsight bias is when an investor or person feels that an outcome could have been predicted, even though it was impossible. There are many factors that lead to events such as price increase for a security, and the repetition of similar events will not necessarily lead to similar results. This will lead to frustrations as investors will feel that missed successes could have been predicted and will make investors prone to making a decision based on a similar series of events in the future. This can be quite dangerous as it is easy to forget that past performance is not indicative of future results.
Recency.
The recency bias is when an investor focuses on short term data opposed to taking into consideration the longer term data. Investors are particularly vulnerable to this bias as many will only consider short term (<1 year) attributes when considering an investment, when a much longer time horizon should be used. An example would be a sharply increasing stock is seen as a good investment, when in fact it could be a cyclical stock and a downturn could be imminent as the stock is already fully valued.
Framing.
The framing bias is the tendency to see particular situations differently, depending upon the surrounding circumstances. An everyday example is when a person goes to the grocery store and sees deals like “2 for $5” and, even though the price is $2.50 each, people will tend to buy 2 at a time. This bias is used in media and sales in the investment world in order to play on the emotional response of investors. The framing of a statement should have no bearing on the underlying data of making a decision, so it should not affect investment decisions, but it does.
Emotional Biases
Endowment.
The endowment bias shows that an investor places more value upon investments that they own, opposed to investments that they do not. This can lead to investors holding onto investments unnecessarily despite a more favourable alternative being available.
Self-Control.
The self-control bias is actually the typical behaviour of an investor willing to spend recklessly at the cost to be paid later. The disregard for future consequences can cause people to be impulsive and act on something in something immediate without carefully considering the data available. Many investors realise the lack of self-control and will opt for funds to be withheld from them to avoid future confrontation with making bad decisions.
Optimism.
The optimism bias is the natural tendency to think of one’s self as being better than others based on very little data. A prevalent example is active investing, which by nature implies that the active investor believes that they are smarter than the market and can outperform their peers. However, the entire active market is buying and selling with each other, and they all can’t be right, so it cannot always be true.
Loss Aversion.
The loss aversion bias means that people generally feel a stronger impulse to avoid losses than to acquire gains(4). The motivation to avoid a loss is roughly twice as powerful as the motivation to obtain a gain of equal magnitude. An example would be if someone were offered a coin flip (50/50 chance) where they could win $100 or lose $75, they will most likely not participate. This impact can lead to unnecessarily conservative investment strategies when more risk should be taken.
Regret aversion.
The regret aversion bias is when a person avoids making a decision due to the fear that, in hindsight, whatever they decide on will result in a bad decision. The regret-averse investor will focus on the regret felt from the worst possible situation after a decision and base their action on that. This will lead to an overweighting on the probability of a negative outcome and lead to an inappropriately conservative strategy.
Status Quo.
The status quo bias occurs when an investor is faced with a significant amount of options, they will typically choose to remain the same. In investing, this can lead to unnecessary emotional attachments to securities and lead to the tendency for in investor to hold onto a failing investment opposed to exploring the options.
Becoming familiar with these biases and acknowledging them can help the investor avoid possible mistakes when selecting an investment or wealth manager. Once a bias has been identified, the investor can step back and process the information again in order to make a more data driven, responsible choice to make wealth management decisions that coincide with their long term goals.
1 The American Heritage Dictionary of the English Language, Fifth Edition. Copyright 2015 by Houghton Mifflin Harcourt Publishing Company.
2 S&P Indices Versus Active Scorecard.
3Thaler, R. H. “Towards a positive theory of consumer choice.” Journal of Economic Behaviour and Organization, 1, 1980, 39-60.
4Kahneman and Tversky, “Prospect theory: An analysis of decision under risk”. Econometrica, 47, 1979, 263-291.
Canadian Securities Institute, “What Are Investment Biases”. Advanced Investment Strategies, 92-97, 2016
