Three Behavioral Biases that Affect Investment Decisions

Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha
Dec 3, 2019 2:35:13 PM 4 min read

Controlling your emotions is probably the single simplest, yet most difficult, way to improve investing performance - especially equity investment performance. Emotions are affected by behavioral biases and it is part of human nature to be affected by these biases. Although they are difficult to manage, the first step to controlling behavioral biases is being aware of them.  Below are a few of the most common.


Disposition Effect (Pride and Regret)

Investors sell winners to soon and hold losers too long because of the feeling of pride or regret that each decision causes. For example, if I own a stock that has gone up in price, I will be proud when I sell it for a gain. But conversely, if I own a stock that has gone down, I will be forced to recognize some regret when I sell it because I will be admitting to myself the purchase was a mistake. The result is that I prefer to sell winning stocks and I postpone the selling of losing stocks because I want to maximize the pride I feel and minimize regret. A great academic discussion of this phenomenon can be found here.

This tendency has some fairly obvious adverse consequences. In a world where capital gains are taxed at the time of sale, it would be in my interest to sell only losing stocks, deferring my capital gains taxes and in fact maximizing the losses which are beneficial to my tax liability. But if I care more about feeling pride than minimizing my tax bill, I will make the wrong decision. And investors do that all the time.

Anchoring

Behavioral biases do not exist in isolation, and when one bias is at work so too are others. Sometimes they complement each other, other times they do not. 

Anchoring is a bias often caused by the disposition effect. Suppose I bought a stock for $50 that now trades at $45. Although it is largely unimportant, I will be focused on the original price, simply because that is the price I paid. I will be reluctant to sell the stock until it again reaches that level because I have “anchored” at $50. I will feel pride if I sell it for more than $50 and regret if I sell it at its current price of $45.

Of course, there are other values that investors might anchor on. Perhaps it is the 52-week high. The investor might think, “Well I know the stock traded that high within the last year, so I will wait for it to get back up to that level.” Again, selling for less than the anchor point might trigger regret. On average, investors are much more willing to sell for a dollar more than a dollar less.

Optimism and Wishful Thinking

According to the Small Business Administration, only about half of all small businesses survive longer than five years. Those aren’t great odds, yet that doesn’t dissuade most entrepreneurs to try. One reason is that entrepreneurs are optimistic. Convincing themselves that they will be among the half that survives is only natural, and often beneficial because it encourages them to work hard. Yet optimism about issues outside of one’s control is a bit more problematic.

In the stock market optimism is often measured by a proxy called sentiment. When investor sentiment is high, investors are systematically optimistic. This can result in prices that get bid higher, potentially beyond management’s ability to deliver performance.  This may be because investors are optimistic about the future only because of the present.

Familiarity Bias

Humans are creatures of habit. They prefer to do what they have always done even when that habit might not be the best method. Most investors are simply more comfortable investing in companies they are familiar with and following familiar routines. This can also be problematic. Consider the investor who buys the stock of the store everyone shops at or the product everyone owns. This isn’t wrong per se, but it can be if the investor places more value on such stocks. I might buy Apple stock because I am familiar with the iPhone, but worse, I might buy the stock because I value stocks that I am familiar with more than those I am not. Note this is not about genuinely having more information about Apple. This is about actually assigning it more value and thus paying more for it simply because I know the company and interact with its products often.

What to do?

Sometimes you are your own worst enemy, and in investing this is due to bias. Understanding behavioral biases are the first step in controlling them, but self-control can be very difficult. One workaround is to take a programmatic or even quantitative, approach to investing. This might mean refusing to analyze a stock on its intangible qualities and instead focus on facts. Make rules and follow them. This takes self-discipline but can be done.

The asset management industry often does a good job of helping investors in this process. If the decision-making responsibility is taken away from the individual and given to a less emotional, often non-thinking portfolio builder, these biases can be managed.

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Julian
Kern
Co-Written by Julian Koski, Co-Founder and Chief Investment Officer and Andy Kern, Senior Portfolio Manager