Behavioural Finance - Part 1 - Cognitive Biases

This article and accompanying podcast is Part #1 in a 2 Part series on this interesting topic. Enjoy!

Cognitive biases: Faulty cognitive reasoning. (Part #1 of our 2-part podcast series)

• Can often be corrected or eliminated through better information, education and advice. 

Emotional biases (Part #2 of our 2-part podcast series)

• Harder to correct because they stem from impulses and intuitions. 
• They arise spontaneously rather than through conscious effort and may even be undesired to the individual feeling them. 
• Often possible only to recognise and adapt, rather than overcome. 

Belief perseverance biases

Belief perseverance biases stem from cognitive dissonance (the mental discomfort experienced when a person holds conflicting beliefs, particularly when newly acquired information contradicts an existing understanding). 

Confirmation: the tendency to look for and notice information that confirms prior beliefs, and to ignore or undervalue whatever contradicts them. 

• Consequences (investors may): 
• Consider only the positive information about an existing investment, while ignoring any negative information. 
• Develop screening criteria while ignoring information that either refutes the validity of such criteria or supports other criteria. 
• Under-diversify portfolios. Investors may become convinced of the value of a single stock or asset class and build a larger position than appropriate. 
• Detection and guidance: 
• Actively seek out information that challenges existing beliefs. 
• Corroborate investment decisions (i.e. look for other information that supports the decision, not the belief). 
  

Representativeness: the tendency to classify new information based on past experiences and classifications (i.e. incorrectly assuming that small sample sizes are representative of populations). 

• Consequences (investors may): 
• Adopt a view or forecast based almost exclusively on individual, specific information or a small sample. 
• Update beliefs using simple classifications rather than deal with the mental stress of complex data. 
• Detection and guidance: 
• Ask yourself - “what is the probability that X (the investment under consideration) belongs to Group A (the group it resembles) or Group B (the group it is statistically more likely to belong to)?” 
  

Illusion of control: the tendency to believe that one can control or influence outcomes when one cannot (e.g. choosing lottery numbers over random ones) 

• Consequences (investors may): 
• Trade more than is prudent. 
• Construct financial models and forecasts that are overly detailed seeking to control the inherent risk and uncertainty of investment outcomes. 
• Inadequately diversify their portfolio (i.e. preferring to hold a large allocation of employer’s stock because of a false sense of control). 
• Detection and guidance: 
• Seek contrary viewpoints. 
• Recognize that investing is a probabilistic activity. 
  

Hindsight: believing past events as having been predictable and reasonable to expect (poorly reasoned decisions with positive results may be remembered as brilliant tactical moves, while poor results of well-reasoned decisions may be described as avoidable mistakes). 

• Consequences (investors may): 
• Overestimate the degree to which they correctly predicted an investment outcome, or the predictability of an outcome in general. 
• Unfairly assess an investment manager or security’s performance. 
• Detection and guidance: 
• Carefully record investment decisions and reasoning and consult records rather than memory when assessing the validity of past decisions. 
  

Processing errors

Illogical or irrational processing and use of information in financial decision-making. 

• Anchoring and adjustment: relying on an initial piece of information to make subsequent estimates, judgments, and decisions (often an initial estimate is “anchored” and not adjusted appropriately). 
• Consequences (investors may): 
• Stick too closely to their original estimates when learning new information. 
• Detection and guidance: 
• Consciously asking questions that may reveal an anchoring and adjustment bias - “Am I holding onto this stock based on rational analysis, or trying to attain a price that I am anchored to (i.e. purchase price or a high water mark)?” 
• Remember that a company’s revenues and expenses (or a portfolio manager’s returns) for a given period reflect conditions in that period

Please make contact with our Financial Planning Team to chat about this topic and your other investment needs.

Stay tuned for Part #2 where we chat about Emotional Biases.