Biases in Behavioral Finance

By

Bitrus Kyangmah Samaila (BSc, MSc.)

PhD Student in Finance, University of Maiduguri, Nigeria.

Introduction

In general, a bias is usually the result of prejudice when making choice over a range of alternatives.

Generally speaking, all kinds of daily activities are primarily driven by behavioral patterns and

psychological makeup of individuals. Biases can be influenced by experience, judgment, social

norms, assumptions, academics, and more. These same factors and some behavioral patterns and

characteristics can also shape and influence investment decisions and actions. Behavioral finance

can be analyzed from a number of perspectives. Stock market returns are one area of finance where

psychological behaviors are often assumed to affect and influence market outcomes and returns

but there are also many different angles for observation.

One of the main aims of Behavioral Finance is to help understand why people make certain

financial choices and how those choices can affect markets. Within Behavioral Finance, it is

assumed that financial participants are not perfectly rational and self-controlled but rather

psychologically influential with somewhat normal and self-controlling tendencies. One of the key

aspects of behavioral finance studies is the influence of biases. Biases can occur for a variety of

reasons. Understanding and classifying different types of behavioral finance biases can be very

important when narrowing in on the study or analysis of industry or sector outcomes and results.

One of the most notable work on behavioural biases is credited to Daniel Kahneman and Mark

Riepe in their paper titled Aspects of Investor Psychology: Preferences and Biases Investment
Advisors Should Know About which leveraged on the decision theory work of Howard Raiffa.

Kahneman and Riepe (1998) categorized behavioural biases on three (3) grounds:

1) Biases of judgement

2) Errors of preference

3) Biases associated with living with the consequences of decisions.

At this juncture, it is necessary to point out that this paper focuses on the biases for judgement with

particular reference to overconfidence bias, self-attribution bias and hindsight bias. We shall now

look at each of them, their implications on investment decisions as well as how to overcome them.

Overconfidence Bias

Human decision-making is often influenced by various types of heuristics, i.e. simple rules of

thumb, and resulting biases that might make a judgment worse. One of these biases is

overconfidence which Kahneman (2011) described as the most serious type of bias due to the fact

that people's judgement is very susceptible to it. Siwar (2011) states that overconfidence is often

defined as the tendency of individuals to overestimate the precision of the available information.

The overconfidence bias may affect all spheres of our lives including important decisions in a

company, with a significant impact on areas such as investments or other managerial decisions

(Prims and Moore, 2017). That is the reason why it is important to pay attention to this type of bias

and to make an effort to find appropriate ways to prevent people from being overconfident, as

overconfidence might adversely affect their judgement during the decision-making process. The

importance of this issue is further strengthened by the fact that experts are victims of

overconfidence too, as pointed out by Dobelli (2013).

Overconfidence in relation to decision-making and economics was probably used for the first time

by Adams and Adams (1960). Moore and Healy (2008) divided overconfidence bias into three

types. The first type is called overestimation and refers to situations when a person overestimates

his/her abilities. The second type of overconfidence bias is called better-than-average or

overplacement and it connotes a person’s belief that she or he is better than average. The last type

of overconfidence bias is overprecision. In this case, a person’s confidence is expressed using

numbers, usually with unrealistic percentages or intervals. Other used forms of overconfidence

according to Herz et. al (2014) are overoptimism (a tendency to overestimate one’s chances of

success) and judgemental overconfidence (a tendency to overestimate the precision of

information).

When studying this concept on subjects within a company, then in the case of a company’s

founders, the overconfidence bias may influence them when they evaluate their entrepreneurship

and their chances of successfully establishing a company in a specific market segment (Zíka and

Koblovsky, 2016). In the case of CEOs, their confidence may have a significant impact on a

company's operations, while they are also in charge of both the decision-making concerning

everyday procedures and decisions about the company's future development. For example,

acquisitions are usually carried out by CEOs whose precision of judgement about the value of an

acquired company, and especially about the value of its shares, might be biased (Skala, 2008).

Moreover, CEOs’ confidence is also closely related to confidence of their employees (Zíka and

Koblovsky, 2016). This systematic review is aimed at the overconfidence bias in CEOs’ decision-

making within a company. The main reason for examining this specific area is the fact that CEOs’
decision-making has a great influence not only on the companies themselves, but also on their

products, services, employees, procedures and other important factors.

Effects of Overconfidence Bias

Decision making is affected by overconfidence bias, in both corporate world and individual

investments. Shefrin (2003) defined overconfidence as showing concern about knowing one’s own

abilities and boundaries of knowledge. Investors could be over-evaluating in their abilities of

performing to the extent that they overestimate their perception and understanding of financial

markets or specific investments and as a result, disregard relevant data or expert opinion or advice.

These often lead to ill-advised resolve to time the market or build concentrations in risky

investments they may consider realistically profitable. It could result in huge losses from poor or

wrong investment decisions as they might be prone to make less than appropriately cautious

investment decisions. Summarily, when a manager is overconfident, his propensity to make

impellent decisions becomes highly inevitable. This explains why investors decide unilaterally

without seeking for expert opinion or help in investment decision making.

How to Overcome Overconfidence Bias

Given the foregoing, overconfidence bias can lead to disastrous consequences, hence the need to

drastically address it whenever the situation arises. Cooper, Folta and Woo (1995) found that

before committing decisions, entrepreneurs search out for information. Survival in short run as

well as long run is fuelled by over-confidence in the context of positive trait of entrepreneurs.

Negativity in bias occurs when entrepreneurs are not aware of their boundaries and therefore,

wrong decisions are being made on erroneous bases. Investors must act as their own devil’s
advocate, pay attention to feedback and think of the consequences of their actions when taking

investment decisions.

Self-Attribution Bias

Self-attribution bias is a long-standing concept in psychology research and refers to individuals’

general tendency to attribute successes to personal skills and failures to factors beyond their control

(Feather and Simon, 1971; Miller and Ross, 1975). Recently, self-attribution bias is also gaining

research attention in the field of household finance (Hoffmann & Post, 2014) as well as

Behavioural Finance. In this regard, this bias is thought to underlie and reinforce individual

investor overconfidence (Barber and Odean, 2002; Dorn and Huberman, 2005). The household

finance literature demonstrates that investor overconfidence is associated with such behaviors as

overtrading (Barber and Odean, 2002) and under-diversification (Goetzmann and Kumar, 2008),

which are detrimental to consumer financial well-being as they lead to underperformance and

portfolios with high idiosyncratic risk.

For the above-mentioned reasons, it is important to increase the understanding of self-attribution

bias in the context of consumer financial decision-making. To date, however, the existence of self-

attribution bias amongst individual investors is only assumed and not directly empirically tested.

For example, it is presumed that self-attribution bias causes successful investors to grow

increasingly overconfident about their investment skills and therefore increase their trading

volume over time (Daniel et al., 1998; Gervais and Odeam, 2001; Statman et al., 2006). Whether

individual investors actually have a self-attribution bias, however, is not measured in such studies.
As a notable exception, Dorn and Huberman (2005) surveyed a sample of individual investors

about whether they judge their past investment successes to be mainly due to their personal skills.

However, they do not test whether these investors indeed attribute good returns to their skills and

bad returns to other factors. Previous studies have shown that managers are likely to overestimate

the extent to which they contribute to positive firm performance, and both overoptimism about

firm performance and overconfidence in their ability to predict future firm performance contribute

to issuance of earnings forecast (Libby & Rennekamp, 2011).

So self-attribution is a cognitive phenomenon by which investors attribute failures of their

investment decisions to situational factors, or market factors, or economic factors, and successes

to dispositional factors such as their own skill or intelligence. Self-serving bias can be broken

down into two constituent tendencies or subsidiary biases. Self-enhancing bias basically represents

an investor’s propensity to claim an irrational degree of credit for their investment successes. Self-

protecting bias, on the other hand, represents the corollary effect which is the irrational denial of

responsibility for investment losses.

Due to the fact that investors intend to make profits, there are no outcomes that are in accordance

with that intention, to make money is perceived, as a result, of investors acting to achieve what

they have originally intended. Investors then naturally access more credit for their investment

successes than losses. This is because the initial action was essentially intended to make money

now since they intend to make money rather than to lose. Self-predicting bias can be explained

from an emotional perspective. Investors need to maintain self-esteem, and that need directly

affects distribution of investment outcomes because investors will protect themselves

psychologically in an attempt to comprehend their failures.

Effects of Self-Attribution Bias

Self-attribution bias involves both cognitive and emotional explanations which are linked. This

can be a bit difficult to ascertain which form of bias is at work, in a given investment situation.

Irrationally, attributing investment gains and losses can impair investors in two primary ways.

Firstly, investors who aren't able to perceive mistakes they have made are consequently unable to

learn from those investment mistakes. Secondly, investors would disproportionately credit

themselves when they do make money or they make a profit and can become judgmentally over

confident in their own market suaveness or market skills. It's been observed that periods of general

prosperity in markets are usually followed by periods of higher than expected trading volume, a

trend signifying the impact of overconfidence on investment decision making. And during periods

of overconfidence, our trading volume tends to increase and that, in general, lowers average profits

because of trading costs. Traders, who are both young and successful tend to trade the most and

demonstrate the most overconfidence.

Self-attribution investors can, after a period of successful investing, such as say, one quarter or a

year, believe that the success is due to their aptitude rather than factors that could possibly be out

of their control. This kind of investment behavior can lead to taking on too much risk as investors

become too confident in their investment skills. Self-attribution bias also often leads investors to

trade far too much than what may be considered prudent. If an investor believes that successful

investing or trading can be attributed to his own 100% skill and 0% luck, you know that the

investor will begin to trade too much.

Which we know is hazardous to one's own wealth. Self-attribution bias leads investors to hear

what they want to hear. That is when investors are presented with information that confirms a

decision they have made. They will ascribe brilliance to themselves. This may actually lead

investors to make a purchase or hold on to an investment that they probably should not. They'll

probably purchase a stock or just hold on to the stock that they're better off by not holding. Self-

attribution bias can cause investors to hold under-diversified portfolios, especially for investors

who attribute their success or attribute the fact that the portfolio is making money to their own

skill. And holding a considerable stock position can be associated with self-attribution and you

know should be generally avoided. It's helpful to apply one of the old Wall Street adages that kind

of provides the best warning against pitfalls of self-attribution bias. The adage says that, don't

confuse brains with a bull market. Often times, when financial decisions pan out well, investors

like to congratulate themselves on their skill. When things don't pan out well, don't turn out

profitably, they console themselves by concluding that someone or something else, maybe market

forces, maybe economic forces, or some political events, were at fault. In many cases, neither

explanation may be entirely correct.

Good investment outcomes are typically due to a number of factors. Bull market is the most

prominent among them. And stocks decline in value. And stocks declining in value can be equally

random and complex. And one of the best thing investors can do is view both winning and losing

in the financial markets as objectively as possible. However, most people don't take the time to

analyze the complex confluence of factors that help them make profits or to confront the potential

mistakes that aggravated a loss.

Post-analysis of trading and investment is one of the best learning tools for an investor especially

a young investor and it's understandable. But, ultimately it's quite irrational to fear examination of

one's own past mistakes. The only real grievous error in investment is to continue to succumb to

over confidence, and as a result to repeat the same mistakes again and again. Investors should also

perform a post-analysis of each investment, and the post-analysis can go along the lines, such as,

you could ask yourself, I could ask myself the question, where did I make money, where did I lose

money? I can mentally separate my good money-making decisions from the bad ones and then

review the beneficial decisions and try to discern, what exactly did I do correctly? Did I purchase

a stock at a particularly advantageous time or was the market in general on an upswing? Similarly

as an investor I should review the decisions that I would probably categorized them as poor. So I

should analyze what went wrong. Did I buy stocks with poor earnings? Did I buy stocks with poor

fundamentals? Were the stocks trading at or near their price highs, the peaks when I purchased

them? Or did I pick up stocks as they were beginning to decline? Did I basically purchase the stock

aptly and simply make an error when it came to selling, or was the market in general undergoing

a correction phase? So when reviewing unprofitable decisions, I can look for patterns or common

mistakes. As an investor I should be aware of any such tendencies and try to remain mindful of

such tendencies. For example, I could brainstorm past investment decisions and become conscious

of the rules that can help me overcome any bad habits that I may have acquired. As a trader, and

can also reinforce my reliance on strategies that have served me well. So as an investor, I just need

to remember that admitting and learning from past investment mistakes, is the best way to become

a smarter, better, and more successful investor.

Self-attribution bias is a long-standing concept in psychology research and refers to individuals’

tendency to attribute successes to personal skills and failures to factors beyond their control.

Recently, this bias is also being studied in household finance research and is considered to underlie

and reinforce investor overconfidence. To date, however, the existence of self-attribution bias

amongst individual investors is not directly empirically tested. That is, it remains unclear whether

good (vs. bad) returns indeed make investors believe more (vs. less) strongly that skills drive their

performance. Using a unique combination of survey data and matching trading records of a sample

of clients from a large discount brokerage firm, we find that (1) the higher the returns in a previous

period are, the more investors agree with a statement claiming that their recent performance

accurately reflects their investment skills (and vice versa); and (2) while individual returns relate

to more agreement, market returns have no such effect.

Hindsight bias

Hindsight bias is a tendency to see beneficial past events as predictable and bad events as not

predictable. In hindsight bias one’s present knowledge influences one’s recollection of previous

beliefs (Bernstein, et al, 2007). According to Magellan (2019), in recent years, there has been

many explanations for poor investment performance that blame the unpredictability and volatility

of markets. In each case, people armed with advance knowledge of an outcome overestimate the

likelihood of that particular outcome, in essence claiming that they “knew it all along” (Wood,

1978). In the view of Magellan (2019), some of the explanations are as credible as a school child

complaining to the teacher that ‘the dog ate my homework’. While we have made mistakes, we

will not blame our mistakes on so-called unpredictable events. In fact, not a single mistake we
have made over the past five years could be attributed to an unpredictable event or market volatility

but rather to errors of judgment (Magellan, 2019).

Overestimation of favorable outcomes and their comparison with unfavorable outcomes is being

related to the optimism (Shefrin; 2007). Different fields are being filled with such kind of bias e.g.

debt equity ratio for financing. It has been pointed out by Meinert that, corporate management’s

excess of optimism has caused debt problems (Meinert, 1991). Forecasting bias remains during

introduction of new products in the market. Accordintd to Golden, Miliewicz and Herbig (1994),

most of the time forecasting is erroneous. Existence of company’s excessive optimism is being

dependent on favorable forecasts. Excess of optimism has highly influenced the corporations as

well as individuals when they make decisions in context of investment. Brown and Cliff (2005)

concluded after studying value of stock prices that asset valuation is being influenced by

sentiments.

What causes hindsight bias? One account posits that individuals automatically update their beliefs

with new information, rendering the original information inaccessible (Fischoff, 1975). More

recent theories maintain that hindsight bias results from a biased reconstruction of the original

memory trace, using the outcome as a cue. On this view, the outcome information coexists with

the original memory trace rather than altering or overwriting it (Pohl, Eisenhauer, & Hardt,

2003; Hoffrage, Hertwig, & Gigerenzer, 2000).

Hindsight bias has been found to be more likely occur when the outcome of an event is negative

rather than positive. This is a phenomenon consistent with the general tendency for people to pay
more attention to negative outcomes of events than positive outcomes (Schkade & Kilbourne,

1991). Despite the substantial literature on hindsight bias that exists for adults, there has been little

work on the developmental origins and trajectory of hindsight bias (Bernstein et al., 2004; Birch

& Bernstein, 2007; Pohl & Haracic, 2005).

Implications for Investors

Hindsight bias has its own drawbacks. Magellan (2019) noted that is a dangerous state of mind as

it clouds your objectivity in assessing past investment decisions and inhibits your ability to learn

from past mistakes. To reduce hindsight bias, we spend significant time upfront setting out in

writing the investment case for each stock, including our estimated return. This makes it more

difficult to ‘rewrite’ our investment history with the benefit of hindsight. We do this for individual

stock investments and macroeconomic calls.

We conclude that bias beclouds decision-making judgment and renders investors vulnerable to

making decisions based on irrational prejudices given that they are humans. As a result,

understanding the types of bias can help investors to avoid falling victims to a number of biases.

A bias can be conscious or unconscious. When investors act upon them, they fail to absorb

evidence that contradicts their assumptions and perceptions.

Investors that are smart try to avoid two big types of bias: emotional bias and cognitive bias.

Cognitive biases generally involve decision making based on established concepts that may or may

not be accurate. Emotional biases typically occur spontaneously based on the personal feelings of

an individual at the time a decision is made. Emotional biases are usually not based on expansive

conceptual reasoning. Both cognitive and emotional biases may or may not prove to be successful
when influencing a decision. Controlling them can allow the investor to reach an impartial decision

based mainly on the available data. Relying on bias rather than relevant, hard data can be costly.

In conclusion, for most people, it is impossible to be unbiased in investment decision-making.

However, investors can mitigate biases by understanding and identifying them, then creating

trading and investing rules that mitigate them when necessary.

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