Avoiding Investment Bias

Avoiding biases in investing can be challenging for even the most seasoned investors. Download and share our free guide and start reining in any cognitive biases you may have.

Avoiding investment bias photo of contemplative man.

Cognitive Bias Can Happen to Anyone

When the market is relatively stable, the brain generally resides in a relaxed state. When the market is volatile, the brain elevates to a scared or even angry state. These elevated states make it difficult for investors to keep from inflating possible risks and dangers through a variety of cognitive biases.

Even savvy and experienced intelligent investors who have a good understanding of investing principles may begin to make rash decisions during periods of market volatility. Along with a variety of cost benefits of working with a professional financial advisor, one of their objectives is helping you manage these innate tendencies and behaviors.

Psychology of Risk-Taking and Risk-Aversion in Avoiding Investment Bias

According to a landmark study on prospect theory and risk aversion, people are more likely to be concerned about avoiding loss than they are about the possibility of gains. When it comes to successful investing, we can see how that stance might be counterintuitive.

Many layers help define the psychology behind risk-taking, risk-aversion, and investment behavior. These layers can include perceptions, intuition, personality, and emotions. Any combination of these characteristics can influence our level of risk-taking in some way. With a short assessment, you can get your risk number to see if your portfolio matches your risk tolerance.

Our guide covers strategies for avoiding investment bias including these top six:

  • Overconfidence bias
  • Familiarity bias
  • Information overload
  • Anchoring
  • Herding bias
  • Loss aversion

Decision-Making

See no evil, hear no evil, speak no evil, strategies for reducing cognitive bias in investing

 

The nuts and bolts of the psychology of investing show several interesting behavioral outcomes:

  • Framing – Research shows that even a slight variance in variables can affect how an investor makes choices, even if given the same options in a different order
  • Source Dependence – Investors often lean toward options that fall within their area of competence
  • Risk Seeking – People prefer to select a sure loss over the possibility of a larger loss. Conversely, they prefer to select a small probability of a large gain over a measured gain.

4 Approaches to Investment

Investors generally fall into one of four distinct risk approaches:

  • Avoiders – These investors look for guarantees on return of investment and will often settle for less return to avoid a loss. This group doesn’t generally expend much energy on research and is usually behind their counterparts in retirement savings.
  • Mitigators – These investors are more likely to take risks because they thoroughly investigate them. Though they generally have diversified portfolios, they tend to get overly nervous about market fluctuations.
  • Managers – These investors are inclined toward a high level of confidence and view themselves as quite savvy. Consequently, they run the risk of letting that confidence slip from their control.
  • Seekers – Thrill-seeking and excitement are catalysts for taking chances. These investors do not spend much time researching nor are they usually well diversified. They tend to make snap investment decisions without fully considering the consequences.

Though some people may exhibit multiple approaches depending upon the investment, they usually lean toward one particular approach as their fallback.

A Closer Look at Risk at Risk Models in Avoiding Investment Bias

An investor’s perception of risk can be colored by a multitude of factors. There are cognitive elements that are made up of one’s knowledge and understanding of risk, coupled with emotional elements running the gamut of how investors feel about risk.

Measurement of risk perceptions has been hotly debated through the years by financial advisors, industry regulators, and researchers alike. Several models have been proposed by researchers which might help investors understand how they process information and make decisions:

  • Risk Perception Model –  Investors generally accept risks that they view as involuntary.
  • Mental Noise Model – Stress, disaster, dread uncertainty, vulnerability, and familiarity reduce decision-making ability.
  • Negative Dominance Model – Anxiety-producing situations are more likely to cause hyper-focus on negative messages.
  • Trust Determination Model – An investor’s perceived level of trust can affect their reaction to risk.

Social and Cultural Factors

Research shows that humans generally form an optimum balance between risk and any benefit it might be associated with. Unfortunately, this scenario also applies to undesired social and cultural factors:

  • Voluntary and Involuntary Risk – When weighing an activity, people generally accept greater voluntary risk. For example, research shows that people view an activity such as rock climbing as having less risk than the involuntary risk of drinking fluoridated water, though more people are affected by their drinking water than engage in rock climbing.
  • Informed Risk – People generally perceive risk levels in the current moment as higher than those already experienced. This explains why current topics like genetically modified food are ranked riskier than cleaning ears with a cotton swab, despite the greater risk for injury that cotton swabs pose.

The good news for avoiding investment bias is that investor risk tolerance can be measured. By studying a person’s willingness to engage in risky financial behavior, financial advisors can work to mitigate these factors.

Key Influencers in Our Understanding of Risk

Strategies for reducing cognitive bias in investing

When it comes to our money, humans are not exactly rational investors. Many key influencers enable investors to misperceive the frequency and magnitude of risk.

Heuristics

Several heuristics can negatively affect an investor’s perception of risk and impact their best intentions. Key influencers include:

  • Media Influence – Public awareness by the media can influence an investor’s perceptions depending upon the amount of coverage, how the message is framed, the tone of the message, the trustworthiness of media sources, and the format in which information is presented, and source channels.
  • Availability heuristic – Heuristics suggests that when people are aware of risks, they make assumptions that those risks occur more frequently than is reality.
  • Affect heuristic – Relying upon current emotions to make decisions about risk.

Cognitive Biases

Six main cognitive biases can be harmful to investors. These detrimental biases can derail investors’ ability to make the best possible decisions about building their wealth.

Overconfidence

Investors may overestimate the confidence level and the accuracy of their judgment as greater than the objective accuracy of those judgments. In other words, the subjective estimation of our accuracy and reliability is greater than it objectively is. This bias can result in an investor that has an unrealistically positive view of performance and results. What to do – To overcome relying on confidence rather than data, it is important to ask if our judgment is based upon our level of knowledge, or if we have applied due diligence in research and fact-gathering.

Familiarity

Investors often make assumptions during the decision-making process based on patterns and outcomes previously observed. For example, we may select funds to invest in that are the most familiar or ones we recognize. This bias can result in an investor that is immobilized, despite the possible benefits that can come from diversification. What to do – To put this bias to rest, we must understand our need to seek out patterns where there are none and commit to remaining open-minded about things we may not have heard of before.

Information overload

When we are under stress or are being hit by too much information, we naturally adopt coping mechanisms. One of these mechanisms is to over-simplify the problem. But the less knowledge and understanding we have about our investments, the less well we cope. This bias can result in an investor that becomes paralyzed at the prospect of too many choices. What to do – To control our innate desire to over-simplify issues, we must tap into our patience and affirm to ourselves that we are not simply taking the easy way out rather than doing the work necessary to reap the benefits.

Anchoring

Once an option presents itself, we sometimes anchor ourselves to this original piece of information, failing to sufficiently consider the realm of other possibilities. This means we selectively filter out information, preferring to focus on data that supports our view. This bias can result in an investor that may only look at options that support their original view, rather than seek out information that informs other views. What to do – While it is important to recognize that historical data can provide us with great insight into current data, we must ensure we do not automatically adopt historical conclusions.

Herding

This bias takes place when rational people begin behaving irrationally, by limiting judgment based on what others are doing. We often look to others, including institutions, for affirmation and acceptance, allowing them to color our judgment. The same holds true as we gravitate to investments based upon what others are doing, or what we’ve heard. What to do – To stop ourselves from selectively seeking out the opinions of others in our judgments, we should avoid listening to the “noise” and instead, seek out verifiable data. By considering the alternatives, we can fully vet our judgments and help ensure they are not based solely upon what the group is doing.

Loss Aversion

Our experience with loss means we rank them higher than other experiences. Applying prospect theory, our past losses feel worse to us than our past gains feel good.  Sometimes we make decisions based upon the fear of loss so as to avert its occurrence, instead of considering the benefit of potential gain. We may even go to illogical lengths to avoid the loss, which can negatively impact our desired outcome. What to do – To control our tendency to freeze, we should make sure our plans allow for wiggle-room and recognize that statistically, the odds of both loss and gain are equal in strength.

By understanding these six biases we hold the key to safeguarding the negative impact they can have on our decision-making process.

Hone Your Decision-Making Skills

Strategies for reducing cognitive bias in investing

 

It’s hard not to see ourselves as having sound decision-making skills, but our level of risk-taking can be directly related to that skill set.  Honing these skills can help investors make better choices. According to the University of Massachusetts Dartmouth, seven steps can be applied to help you with decision-making:

  1. Identify the decision – are you certain your focus is the right one?
  2. Gather facts and information – do your research
  3. Brainstorm – gather your friends and family and toss around ideas
  4. Identify alternative solutions – think about other paths to achieve your objective
  5. Weigh all evidence collected – scientifically analyze the information
  6. Choose among the alternatives – select from the alternatives you researched and weighed
  7. Take direct action – implement the alternative you selected
  8. Review the decision and consequences – if the result is not what you hoped for, review the steps again

Adopt New Investing Strategies

When it comes to investment risk, perhaps the best option for most people is to think of it in terms of balance. As investors, we should strive not to control fear, which can overinflate the possibility of failure. Conversely, we should limit our inner Superman in underestimating what could go wrong. Both tendencies have a limiting effect and can immobilize us in making decisions.

Several things can help set apart successful investors from average investors. Generally, they:

  • Actively help plan a portfolio that protects and grows for the future
  • Routinely review and monitor portfolio strategies
  • Try to organize your financial life to see where you are in meeting your goals
  • Use an online risk assessment tool that helps you understand your tolerance for risk
  • Download a financial planning app to help you keep track of your portfolio, in real-time
  • Begin a “news diet” and dial down the television, radio, and online news for a while

Seek Professional Advice

Simply informing people of risk is not enough. A trusted advisor should recognize that everybody is different and help manage and control these emotions and natural tendencies toward cognitive bias. A good financial advisor will understand and legitimize your concerns about risk and help you place them in perspective. This is where the cost benefits of using a professional financial advisor are realized.

Get Our Free Guide to Avoiding Investment Bias

We all know there is a lot of misinformation on the web.  That’s why, as part of our GWA Gives© program, we are dedicated to helping others find sound advice.  We believe in sharing free material so people have a trusted source to rely upon.

While investment strategies can be complicated and avoiding investment bias is only one aspect of successfully building a portfolio.  Let us know if we can answer any questions you might have.  You can reach us at one of our convenient offices listed on the Contact Us page or by filling out the chat form below.

Resources

Chan, Jean Lee & Eduardo, B. Andrade (2014) Fear, excitement, and financial risk-taking, Cognition and Emotion, 29:1, 178-187. doi:10.1080/02699931.2014.898611

Paek, H., & Hove, T.  (2017, March 29). Risk Perceptions and Risk Characteristics. Oxford Research Encyclopedia of Communication.  Retrieved from.

Slovic, P. (1987). Perception of risk. Science, 236(4799), 280-285. doi:10.1126/science.3563507

Tversky, A., & Kahneman, D. (2016). Advances in Prospect Theory: Cumulative Representation of Uncertainty. Readings in Formal Epistemology, 493-519. doi:10.1007/978-3-319-20451-2_24

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