When an investor makes financial decisions, in addition to a rational and critical analysis, different psychological mechanisms, known as cognitive biases, influence his or her decisions. In this article we will analyse what are the most common investment biases and how you can minimise them in your investment decisions.
What are cognitive biases?
Biases are tricks or shortcuts that our brain uses to simplify the large amount of mental processes it carries out constantly, in order to make our daily lives more manageable.
The term cognitive bias was coined in the 1970s by Amos Tversky and Daniel Kahneman. Kahneman, Professor of Psychology at Princeton University, received the 2002 Nobel Prize in Economics for his contributions to behavioural economics or economic psychology. Along with Kahneman, the other key name in behavioural economics is economist Richard H. Thaler, whose studies in this field were also awarded the Nobel Prize in Economics (in 2017).
What these authors emphasise in their studies is that the subjects are not purely rational beings, but instead emotions and intuition play a fundamental role in making their decisions. Research in this area shows that most of these biases are predictable.
Types of investment biases
Experts have documented more than a dozen biases that influence the investment process. Many of them have been collected in the study by the Credit Suisse Research Institute and the University of Zurich "Behavioral Finance: The Psychology of Investing”, written by professors Thorsten Hens and Anna Meier. The National Securities Market Commission (CNMV) also covers them in its guide "Economic psychology for investors". These are some of the most common investment biases:
- Country bias. This is the predisposition of investors to buy shares in companies that come from their country of origin. These shares seem more trustworthy since investors grew up knowing the names of these companies, which are also mentioned more often in the local media.
- Anchoring bias. It is the tendency to give more importance to the first information obtained than to new information that contradicts it. In investments, the anchor effect is to have the entry price of an investment as the only reference. If the markets are not favourable, having that single price as a benchmark can lead to hasty decision making, causing the investor to withdraw at the least appropriate time under pressure due to that reference. Another example where you can see how anchoring bias works is when you first present the past performance of an investment product, which makes you not look at other aspects of the product that are not as positive, such as its risks.
- Availability cascade or attentional bias. This bias explains that things (such as products, companies and issuers) that are presented more frequently in the media will be remembered more quickly by investors when they are looking for a suitable investment instrument. In the same way, you will believe that there is a greater chance of an event repeating itself if you are more familiar with it or if you have had close contact with it even though this is not really the case.
- Loss aversion. This bias refers to the tendency to consider losses to outweigh gains. According to a study by Kahnneman and Tversky, our brain perceives losses with an intensity 2.5 times greater than the reward. In other words, you won't take gaining 1,000 euros the same as losing the same amount because the human brain always tends to oversize the loss.
In practice, loss aversion may lead you not to invest because of the possibility of losing your investment, or to maintain an investment with minimal prospects of recovery so as not to incur a loss. This can also lead to shortsightedness. This occurs when we are constantly assessing the value of our portfolio and we overreact to the latest news. Shortsightedness means the investor loses perspective in terms of their investment.
- Mental accounting. This bias explains why people organise and spend our money according to different criteria, such as where it comes from or what we are going to spend it on. Logic dictates that money should be interchangeable, regardless of its origin or the use to which it is put, i.e. one euro has the same value wherever it comes from.
However, your mind does not feel the same way, and so it will treat a euro you have earned with your effort differently than one that comes from chance. Isn't it easier to spend 100 euros you have won in the lottery than 100 euros from your paycheck? The same thing happens when you organise your budget by separating it into different categories: for example, food, rent, leisure, savings. Normally you will make your financial decisions by calculating the effect on each one of them and not on the overall income.
Similarly, many investors divide their investments into separate accounts (mental and physical). As Hens and Meier's study says "often the losses incurred are considered separately from the losses on paper.
This means that people sell shares in their portfolio too early when they make a profit and too late when they suffer a loss.
How do you deal with bias?
Although they cannot be made to disappear, the biases that an investor is subjected to every time she/he decides what to do with their money can be mitigated. Experts have identified two ways to do this:
- by acquiring sufficient financial knowledge
- by using cognitive techniques that help to interpret the elements involved in making a decision in a different way
For example, one way to minimise the effects of the anchoring bias could be to make regular subscriptions and to take into account that having lost or gained money on an investment in the past is not relevant to future performance.
As for the country bias, the investor should consider if this is not limiting his/her opportunities, and just as if he/she had to form a team with the best football players, if it would not be of interest to add investments from other countries to his/her portfolio.
To counteract the availability bias, it is advisable to question why a particular instrument has been identified (for investment) and to seek advice from a neutral party.
With reference to loss aversion, the answer is to use a long-term investment strategy and to not allow emotions to guide us in financial matters. Meanwhile, the solution for dealing with the problem of mental accounting bias is to remember that money is fungible, regardless of its origin or intended use.
In short, when we talk about financial decisions, it is not only appropriate to seek advice and proven information, but it is also essential to consider the advantages and disadvantages of the different options before making a decision and to not let ourselves be guided by investment biases.