To maximise our profit when investing in financial instruments we try to rely on analysis of the underlying values, macroeconomic trends and possibly other quantitative methods. However, as much as we try to optimise our returns, we often fail to do so, as we fall prey to our own cognitive and emotional biases. Cognitive biases can be described as rules of thumb or heuristics deployed to save time. They are tendencies to think or act in a certain way that leads to systematic deviations from standard rational decisions. Emotional biases on the other hand occur when we base our actions on feelings instead of facts, which is an ingrained psychological tendency in humans that is very hard to control. This distinction is of course not exclusive and there are many overlaps between emotional and cognitive biases, however, some tendencies can be very clearly attributed to the one or the other category.
Despite the high costs many investors can attribute to such behavioural shortcomings, awareness about and most importantly control of these biases remains quite scarce. Several well-known phenomena such as Conformity or Herding Bias and the Gambler’s Fallacy are intrinsically difficult to circumvent for investors. Others, less publicised tendencies such as Probability Neglect and Inconsistency Avoidance have not yet come to investors’ attention, so they still have to develop an awareness and control mechanisms for them.
As mentioned before simply erasing all cognitive and emotional biases is impossible, as many of them have been adopted for justified reasons, such as self-protection. However, becoming aware of the influence, which psychology can have on our investment decisions enables investors to control these behaviours and tendencies. Therefore, this article outlines several core cognitive and emotional biases affecting our decision-making processes and relates commonly observed phenomena in financial markets with them.
Incentive-caused Bias is a human tendency to act in accordance with one’s self-interest. It is especially dangerous for the service sector, for example in insurance, brokerage and real estate agencies. A quote attributed to Warren Buffett depicts the major issue lucidly: “Don’t ask a barber whether you need a haircut”. In this simple and elegant sentence, he points out how dangerous it is to receive objective and honest advice from people when their compensation (sometimes maybe even a very large portion) depends on the advice they give.
These incentives are core to any reward and punishment biases. These do not only work in agency relationships as explained above, but also in direct interactions among people. On one hand we can influence others’ behaviour by offering rewards or punishments. A well-known example is the Persian Messenger Syndrome that establishes why managers who are known for their short temper when receiving bad news are likely to lose track of what is truly happening in their business. If employees know they will be fired upon delivering bad news, they will either work harder (but only if the rewards are acceptable) or they resort to tampering their results slightly so the manager will be appeased. Neither action is sustainable for a business in the long run. On the other hand, we can influence our own actions by setting rewards and punishments. The Granny’s Rule: “you will not get any dessert unless you finish all the carrots on your plate first” is the prime incorporation of this bias. If you set yourself a reward for completing an unpleasant task first, you are more likely to finish this task quickly and thereby tricked yourself into good work.
The most widely known cognitive and human behavioural bias is the so-called bandwagon effect or herd behaviour. Humans prefer mirroring the actions and beliefs of a large group of people rather than thinking independently. Even John Maynard Keynes was well aware of this tendency and wrote in The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” This bias is the consequence of social conformity pressures and the argument that if many people act in a certain way, this has to be the correct way. It is also among the sources of most speculative bubbles, as investors get caught up in a valuation frenzy and neglect independent analysis of the investments’ real underlying values. Such behaviour can only be mitigated by sticking rigorously to objective benchmarks and quantitative methods to make investment decisions and restraining from conforming with the masses.
Gambler’s Fallacy and Confirmation Bias
In producing a fully-fledged speculative bubble, the Gambler’s Fallacy is an equally relevant cognitive bias. It is the tendency of investors to rely on past stock movements to form their expectations of future developments whilst neglecting factual data on intrinsic values. Driven by this bias, investors became heavily involved in the housing loan market in the build-up to the 2007 financial crisis in the US, as they only paid attention to the past stable increase in housing prices that did not seem as if it had reached its climax yet. Relying on this perceived security, investors failed to recognize the detachment of prices from the underlying assets’ values.
Some investors were probably aware of this inconsistency between prices and intrinsic values and maybe tried to inform their colleagues of these doubts. However, another psychological bias inhibited other investors from recognizing the truth in such worries. Confirmation bias is a human tendency to seek out and emphasise information that confirms one’s existing conclusions and to ignore facts that disagree with these opinions. This psychological inclination may lead investors to become overconfident as every evidence sought out seems to support their decisions. Neglecting to ask themselves why a decision could actually be wrong, investors risk to be blindsided when something negative happens.
Inconsistency Avoidance and First Conclusion Bias
A rather less known behavioural tendency that has equally large influence on investment decisions is Inconsistency Avoidance. Humans try to stick to their committed path of action and beliefs, especially so when they made this commitment publicly or if it is the result of a hard-won conclusion. Therefore, investors may continue to target certain asset classes despite being aware of a speculative haze, simply because they do not want to back away from an earlier commitment to this asset class. This is closely related to the human difficulty in admitting errors and an attempt to make a sophisticated impression.
Coupled with Inconsistency Avoidance, the First Conclusion Bias is a tendency to jump and stick to the first conclusion one draws. This can be very dangerous because when searching for the answer to a question, the mind is prone to jump to the first logical solution and then stick to it (reinforced by Inconsistency Bias we already mentioned). After jumping to a conclusion, the brain does not allow other ideas to freely roam and look for better ideas, which further leads to reduced objectivity and irrationality.
Availability Trap Bias
An influence on First Conclusion biases may come from the Availability Trap bias, a tendency to overweight easily available information such as fresh news, trends, or something that you have just been told by a friend. Humans often rely on these easily received information rather than researching a topic thoroughly using various objective sources. This naturally creates noise in decision-making processes, and it is important to be aware of this while striving for objectivity in anchoring our expectations and predictions.
Probability Neglect Bias
Probability neglect is a subtler failure of investors, which may play into a speculative frenzy. A tendency to chase the possible and to disregard the probable outcome leaves investors incapable of accepting likely negative events. In finance professions probability neglect plays a large role as investment decisions are often based on point estimates for risk and reward. Confidence intervals and the tightness of the probability distribution of such outcomes are however neglected. Hence, large variations to the upside but also to the downside may not be taken into full account by investors, rendering the investment riskier and lowering its true value.
Ease of Measurement
Another pronounced human tendency is the Ease of Measurement/Physics Envy Bias which is reflected in a love for over-quantification. Namely, professionals in the finance industry (but, also in other professions) like to measure questions of interest with physics-like precision. This is not always feasible when qualitative factors are simply not quantifiable. Already Albert Einstein noted that “Not everything that counts can be counted, and not everything that can be counted counts.” Being aware of such tendencies can help keeping the big picture in mind, when analysing the numbers that determine a choice in the end.
Loss Aversion Bias
The Deprival Super-Reaction Syndrome or Loss Aversion Bias encapsulates the notion that “losses loom larger than gains”. It has been proven that people do not feel gains and losses symmetrically. The magnitude of happiness produced by gaining 100$ is much lower than the amount of discomfort produced by losing these 100$. An example of this can be labour negotiations where management and workers receive different emotional contentment from the deal (side that is losing feels much worse).
Survivorship Bias is a tendency to consider only the winners during an analysis. Failed companies are often excluded from performance studies because they no longer exist. Meaning such negative numbers will not show up in the statistics and a distorted picture of the industry is created. A similar principle is at work in mutual funds. Often, funds that perform poorly are merged with more successful ones or shut-down. They will not show up in the data reflecting the overall performance anymore, so if we base our analysis on these figures, our estimates will be biased to the upside.
Another bias is the Hedonic Treadmill tendency to quickly return to your natural constant happiness level after positive or negative developments in life. In practical terms, the hedonic treadmill is saying that a person aspiring to own a certain house and receive a certain pay will not be happier after getting it. Instead she will adjust her goals and be equally happy as before but now aim for even higher targets. This mechanism can guide people into making bad decisions while pursuing never-ending aims.
Biases from over-influential authorities signifies that people are likely to do things which are not in accord with what they believe is right, because an authority figure demands this action. This bias has been proven in various tests such as airplane simulations with pilot and co-pilot or the famous Milgram experiment. In the finance profession and other deals, it explains why employees sell bad products, even when they know the truth about them, only because their superiors require it.
Lastly, a purely emotional bias, significant for any daily interaction between people is the human tendency to reciprocate. When we are offered something or receive beneficial treatment, we will try to return this favour. Likewise, if someone treats us badly or deceives us, we often engage in tit-for-tat retorts to pay him or her back. The emotional tendencies of liking or disliking enhance the reciprocation bias fundamentally among friends or fiends. In investment decisions reciprocation can be detrimental as it means we base our decisions solely on an emotional reaction and not on factual evidence. To control this behaviour an investor can only repeatedly question his motives for making a certain investment and ascertain that there is objective support for this choice. Eliminating the tendency to reciprocate is impossible and in many other situations of life it is a needed emotional bias to remain an accepted member of society.
There are many other cognitive and emotional biases influencing our investment decisions which we cannot all explain here. Serving as a small summary you might also be interested in anchoring bias, negativity bias, disposition effects, hindsight bias, familiarity bias, self-attribution bias, endowment bias and overconfidence, liking or disliking bias and pain avoiding denial.
Combinations of any number of these biases are termed Lollapalooza effects. A Lollapalooza effect is the most significant issue and can be most detrimental for investors with regards to their decision-making processes. Interacting biases render it more difficult for an investor to rationalise his decisions and regard solely objective and quantitative criteria. As we have mentioned above, many biases actually reinforce each other, which makes it more difficult to break free of them. Any speculative bubble traverses several phases, each characterised by different cognitive or emotional tendencies but all contributing to drive the speculative haze. Investors will engage in irrational and emotionally driven investment choices, that drive the valuation bubble higher and higher. The most likely end to this haze is the bursting of the bubble, which will lead to a rationalisation of investment behaviour and investors becoming aware of all the psychological biases they fell prey to. These investors will work harder to avoid committing the same failures again, but ultimately it is impossible to eliminate ingrained biases and another bubble is likely to build, driven by the same biases as the preceding one.