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How Biases Affect Investor Behaviour: March 2014
How Biases Affect Investor Behaviour: March 2014
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Insight
W
hy do investors behave as they do? Investor be-
haviour often deviates from logic and reason.
Emotional processes, mental mistakes, and in- Investor Behaviour
dividual personality traits complicate investment decisions. What is investor behaviour? The field of investor behav-
Thus, investing is more than just analysing numbers and iour attempts to understand and explain decisions by com-
making decisions to buy and sell various assets and securi- bining the topics of psychology and investing on a micro
ties. A large part of investing involves individual behav- level (i.e., the decision process of individuals and groups)
iour. Ignoring or failing to grasp this concept can have a and a macro level (i.e., the role of financial markets). The
detrimental influence on portfolio performance. decision-making process of investors incorporates both a
Behavioural biases in investing encompass many types. quantitative (objective) and qualitative (subjective) aspect
For example, cognitive biases refer to tendencies to think that is based on the features of the investment product or
and act in certain ways. A cognitive bias can be viewed as financial service. Investor behaviour examines the mental
a rule of thumb or heuristic, which can lead to systematic processes and emotional issues that individuals, financial
deviations from a standard of rationality or good judgment. experts, and traders reveal during the financial planning
Some controversy still exists about whether some of these and investment management process. In practice, individu-
biases are truly irrational or whether they result in useful als make judgments and decisions that are based on past
attitudes or behaviour. Other biases are more emotional events, personal beliefs, and preferences. They establish
in nature. An emotional bias is one that results in taking short cuts or heuristics that can save time but lead them
action based on feelings instead of facts. Given that some away from rational, long-term thinking.
overlap exists between cognitive and emotional biases, we
simply call them behavioural biases. An important aspect
of avoiding such biases is to become aware of them. Thus, By avoiding behavioural biases investors can
by avoiding behavioural biases investors can more readily more readily reach impartial decisions based
reach impartial decisions based on available data and logi- on available data and logical processes.
cal processes.
Our purpose is to briefly discuss investor behaviour, re-
view eight common behavioural biases, and then concen- Understanding investor behaviour can inform investors
trate on two types of investors – overconfident investors and about these biases and help them improve their decision-
status quo investors. Baker and Nofsinger (2002, 2010) and making processes in selecting investment services, prod-
Baker and Ricciardi (2014) provide more detailed discus- ucts, and strategies. As a result of the financial crisis of
sions of investor behaviour including behavioural biases. 2007-2008, the discipline of psychology began to focus even
www.europeanfinancialreview.com 7
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more on the financial decision-making it can increase the capital gains taxes ments, they probably should have a
processes of individuals. This renewed that investors pay and can reduce re- more conservative and hence less risk
interest by the social sciences and turns even before taxes. Following investment portfolio.
business disciplines has spurred new the advice of “cut your losses and let 6. Anchoring. Anchoring is the
research on investor behaviour. your profits run” enables investors to tendency to hold on to a belief and
engage in disciplined investment man- then apply it as a subjective reference
Common Behavioural Biases agement that can generate higher re- point for making future judgments.
Investors exhibit many biases. Few turns. Anchoring occurs when an individual
of these behavioural biases exist in 4. Familiarity bias. This bias oc- lets a specific piece of information
isolation because deep interactions curs when investors have a preference control his cognitive decision-mak-
exist among different biases. None- for familiar investments despite the ing process. People often base their
theless, the following list represents seemingly obvious gains from diversi- decisions on the first source of infor-
some common biases facing investors fication. Investors display a preference mation to which they are exposed
but others may be equally important for local assets with which they are (e.g., an initial purchase price of a
depending on the specific situation. more familiar (local bias) as well port- stock) and have difficulty adjusting or
Baker and Nofsinger (2002), Ricciardi folios tilted toward domestic securities changing their views to new informa-
(2008), iShares (2013), Parker (2013), (home bias). An implication of famil- tion. Many investors still anchor on
and Seawright (2012) provide further iarity bias is that investors hold sub- the financial crisis of 2007-2008 as a
discussion of behavioural biases and optimal portfolios. To overcome this bad experience. As Ricciardi (2012)
how to deal with them. bias, investors need to cast a wider net notes, this results in a higher degree
1. Representativeness. Represen- and expand their portfolio allocation of worry, which can cause them to
tativeness results in investors labeling decisions to gain wider diversification underweight equities in their portfo-
an investment as good or bad based on and risk reduction. Investing interna- lios because they are excessively risk-
its recent performance. Consequently, tionally helps to avoid familiarity bias. and loss-averse. To avoid anchoring
“
they buy stocks after prices have risen
expecting those increases to continue
and ignore stocks when their prices are
Regret aversion can explain investor reluctance to sell
below their intrinsic values. Investors “losing” investments because it gives them feedback that
should have a clearly defined analyti- they have made bad decisions. Disciplined investing re-
cal process that they test and retest in quires overcoming the reluctance to realise losses.”
order to refine and improve it over the
long run.
2. Regret (loss) aversion. Regret 5. Worry. The act of worrying is investors should consider a wide range
aversion describes the emotion of re- an ordinary and unquestionably wide- of investment choices and not focus
gret experienced after making a choice spread human experience. Worry their financial decisions on a specific
that turns out to be either a bad or educes memories and visions of future reference point of information.
inferior choice. Investors who are in- episodes that alter an investor’s judg- 7. Self-attribution bias. Investors
fluenced by anticipated regret are mo- ment about personal finances. Based who suffer from self-attribution bias
tivated to take less risk because this on survey evidence, Ricciardi (2011) tend to attribute successful outcomes
lessens the potential of poor outcomes. finds that a much larger percentage to their own actions and bad outcomes
Regret aversion can explain investor of responding investors associate the to external factors. They often exhibit
reluctance to sell “losing” investments word “worry” with common stocks this bias as a means of self-protection
because it gives them feedback that (70 percent) as compared to bonds or self-enhancement. Investors af-
they have made bad decisions. Disci- (10 percent). More anxiety about an flicted with self-attribution bias may
plined investing requires overcoming investment increases its perceived risk become overconfident, which can lead
the reluctance to realise losses. and lowers the level of risk tolerance to overtrading and underperformance.
3. Disposition effect. Closely relat- among investors. In turn, this concern Keeping track of personal mistakes
ed to regret aversion is the disposition increases the likelihood that investors and successes and developing account-
effect, which refers to the tendency of will not buy the security. To avoid this ability mechanisms such as seeking
selling stocks that have appreciated in bias, investors should match their lev- constructive feedback from others can
price since purchase (“winners”) too el of risk tolerance with an appropriate help investors gain awareness of self-
early and holding on to losing stocks asset allocation strategy. As a quick attribution bias.
(“losers”) too long. The disposition test, if investors cannot sleep because 8. Trend-chasing bias. Investors
effect is harmful to investors because of apprehension about their invest- often chase past performance in the
mistaken belief that historical returns predict future invest- Overconfident Investors
ment performance. Mutual funds take advantage of inves- Investors often exhibit overconfident behaviour resulting in
tors by increasing advertising when past performance is high severe consequences. They may display overconfidence in
to attract new investors. Research evidence demonstrates both the quality of their information and their ability to act
that investors do not benefit because performance typically on it. Ricciardi (2008) observes that people tend to over-
fails to persist in the future. For example, using a sample estimate their skills, abilities, and predictions for success.
of 1,020 domestic actively managed mutual funds, Soe and Research documents that overconfident behaviour is con-
Luo (2012) show that using past performance as a strategy nected to excessive trading and results in poor investment
fails. For the five years ending March 2012, only about 5 returns. It can also lead to investors failing to appropriately
percent of the funds maintained top-half performance rank- diversify their portfolios.
ings over five consecutive 12-month periods, while 6 per- Barber and Odean (2001) study the role of trading be-
cent were predicted to repeat by chance alone. To avoid haviour and gender bias for a sample of 35,000 individual
this bias, investors should resist following the herd or jump- accounts over a six-year period. Their findings reveal that
ing on the bandwagon. Although investors may feel better males are not only more overconfident about their invest-
when investing with the crowd, such an investment strategy ing abilities but also trade more often than females. Com-
is unlikely to lead to superior long-term performance. pared to women, men also tend to sell their stocks at the
incorrect time resulting in higher trading costs. Women
These eight behavioural biases are some fundamen- generally trade less and apply a “buy and hold” approach
tal issues investors might face at different periods during resulting in lower trading costs.
their lifetimes. Another important issue to consider is the To resist this bias, investors need to recognise the signs of
amount of attention and time they should spend on their overconfidence such as attributing a few short-term “wins”
investment decisions because this might result in overconfi- to superior knowledge, abilities or skills. Short-term perfor-
dent or status quo behaviour. mance may be more a stroke of luck than security selection
or market timing skill. Individual investors are unlikely
Two Different Types of Investors to have better information, intuition or analytical powers
Most investors can be classified as either overconfident or sta- than others. In fact, the market has made fools out of many
tus quo investors. Overconfident investors tend to be overly respected but overconfident investment professionals. Ul-
active traders and status quo investors display a lack of atten- timately, individuals should be investing for the long-term
tion to managing their portfolios. The best advice is to find an rather than trading for the short-term.
appropriate balance between the two types of investors.
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