The nature of the investment process is a cyclical one, fraught with pitfalls that come under many guises. The aim of this article will be to focus on how investment decisions can be influenced by behavioural biases, specifically cognitive and emotional bias.
First, it will be important to understand the terms we are dealing with and how a perfect or ideal investment would be made; after which we will delve deeper into the why’s, how’s and the following consequences.
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It is well established in financial theory that ideally individuals will be informed, consistent and, very importantly, rational with their investment decision making. The problem lies in the effect of ticking these boxes; one would need to be consistent in updating their beliefs when receiving new information or to make decisions that are normatively acceptable. Humans by nature are not robotic and therefore susceptible to acting irrationally, even showing patterns of behaving in a counterproductive manner. To paraphrase Alexander Pope; ‘To err is human’.
It’s from human nature, our imperfections and inconsistencies, that the theory surrounding cognitive and emotional bias in our decision making is born. Behavioural finance focuses on the cognitive and emotional effects of investing – using psychology, sociology and in some instances biology to determine how financial behaviour operates. It’s not a phenomenon unique to investment, but certainly worth taking note of should you wish to enter into it or improve upon your existing portfolio.
So, to define the terms and explain the difference between cognitive and emotional bias we should begin by noting that we all have bias. They’re how we make decisions in our day to day lives and are not without their uses. Unfortunately this doesn’t always translate into investment. Cognitive bias is routed in statistical, information processing and errors with memory; whilst emotional bias stems from our impulses and intuitions – resulting in us taking action based on a feeling or instinct rather than a fact.
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Within these umbrella terms there are a few signifiers that crop up more often than the others. I shall detail these below.
Under emotional bias, overconfidence is a common trait in investors who believe they have more control over their investments than they really do. The ability to predict complicated scenarios is not an easy feat, and a pitfall of an overconfident and overzealous investor. Typically, this is a trait found in the experienced investor, who as a demographic are very generous when attributing their skills to their portfolio performance. At its extreme, overconfidence has been found to be a major influence in investors who become involved in fraud.
According to multiple studies, it has been proven that investors who trade excessively can actually have sub-par performance levels in the market. This has been proven to correlate to an overconfidence trait in people that drives them to be over-active traders, resulting in lower returns.
The intricate nature of investment can mean there are multiple factors, ideally noticeable but not always, that can affect the result. The relationship between these factors and the investor is known as self-attribution bias. This bias is often depicted as a means of self-protection or enhancement, depending on whether their investment is negative or positive. For example, an investment that proves positive but for reasons unknown to the investor may result in false self-enhancement. The result of this can cause overconfidence which as we know can lead to underperformance. The best and most efficient way to mitigate these effects is to have a journal in which you would track mistakes and successes. This will create a knowledge-bank from which you can draw and also develop accountability mechanisms.
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The above examples are far from an exhaustive list of biases we as humans have to tackle to become successful investors. There are countless others, including; Anchoring, Cluster Illusion, Bandwagon Effect and the Blind Spot Bias.
In recognising the existence of the many biases we’re born with you are on the right path, not for a cure, but to mitigate their effects. By employing systems meant to combat these instincts or gut feelings, such as audit trails or keeping a journal, we are then free to make better weighted decisions and expand on our chances of investment success. No matter your level of investment, whether it is casual or within a professional environment, you will certainly benefit by understanding yourself and the forces at play affecting your decisions.
Professor Richard Thaler predicts that one day behavioural finance theory will not be as divisive as it has been and that eventually the practices will become mainstream; commonly used amongst a variety of investors in financial and economic models. Current behavioural financial theory is clearing the shroud and opening up corridors for niche fields such as neuroeconomics and cultural finance; a step further into better understanding how we operate on deeply personal micro and macro scenarios.
We have opened a very important door in terms of understanding and improving how we operate; the challenge now is to research and educate at all levels. Becoming aware of behavioural and cognitive bias is your first step through that door.
Las Vegas is busy every day, so we know that not everyone is rational – Charles Ellis.