Behavioral Biases of Investors

Mohd. Anisul Islam, CFA

Assistant Professor
March 2021
The Behavioral Biases of Individuals

Introduction
 When people are faced with complex decision- making situations that
demand substantial time and effort, individuals may follow a more subjective,
suboptimal path of reasoning to determine a course of action consistent with
their basic judgments and preferences.
 Individuals strive to make good decisions by simplifying the choices
available, using a subset of the information available, and discarding some
possible alternatives to choose among a smaller number.
 By understanding behavioral biases, investment professionals may be able
to improve economic outcomes. This may entail identifying behavioral biases
they themselves exhibit or behavioral biases of others, including clients.
Availability Bias

Introduction
 Easily recalled outcomes are often perceived as being more likely than
those that are harder to recall or understand.
 People often unconsciously assume that readily available thoughts, ideas,
or images represent unbiased estimates of statistical probabilities.
 There are various sources of availability bias. The four most applicable to
financial market participants are: retrievability, categorization, narrow range of
experience, and resonance.
Availability Bias

Consequence and guidance to detect and overcome

 Choose an investment, investment adviser, or mutual fund based on
advertising rather than on a thorough analysis of the options.
 Limit their investment opportunity set.
 Fail to diversify
 Fail to achieve an appropriate asset allocation.
 investors need to develop an appropriate investment policy strategy,
carefully research and analyze investment decisions before making them, and
focus on long- term results.
 When selecting stocks, it is crucial to consider your availability bias.
 Humans generally disregard or forget about events that happened more than
a few years ago.
Loss- Aversion Bias

Introduction
 Loss- aversion bias is a bias in which people tend to strongly prefer avoiding
losses as opposed to achieving gains.
 Rational FMPs should accept more risk to increase gains, not to mitigate
losses. However, paradoxically, FMPs tend to accept more risk to avoid losses
than to achieve gains.
 Loss- aversion bias leads to risk avoidance when people evaluate a
potential gain.
 Kahneman and Tversky describe loss-averse investor behavior as the
evaluation of gains and losses based on a reference point. Value function
implies risk- seeking behavior in the domain of losses (below the horizontal
axis) and risk avoidance in the domain of gains (above the horizontal axis).
Disposition effect: the holding (not selling) of investments that have
experienced losses (losers) too long, and the selling (not holding) of
investments that have experienced gains (winners) too quickly.
Loss- Aversion Bias

Consequence and guidance to detect and overcome

 Hold investments in a loss position longer than justified by fundamental
analysis.
 Sell investments in a gain position earlier than justified by fundamental
analysis.
 Limit the upside potential of a portfolio by selling winners and holding losers.
 Trade excessively as a result of selling winners.
 Hold riskier portfolios than is acceptable based on the risk/return objectives
 A disciplined approach to investment based on fundamental analysis is a
good way to alleviate the impact of the loss- aversion bias.
 It is impossible to make experiencing losses any less painful emotionally but
analyzing investments and realistically may help guide the FMP to a rational
decision.
Myopic Loss Aversion and the Equity Premium Puzzle

Benartzi and Thaler (1995)

 Losses hurt roughly twice as much
as gains feel good.
 Even investors with long-term
horizons appear to care about short-
term gains and losses.
 If investors evaluate their portfolios
once a year, loss aversion can
explain much of the equity premium.
 The probability of losses in stocks
is higher for shorter evaluation
periods.
So, myopia leads investors to
perceive a higher probability of loss
in equities.
Are Investors Reluctant to Realize Their Losses

Odean (1998)
Overconfidence Bias

Introduction
 Overconfidence bias is a bias in which people demonstrate unwarranted
faith in their own intuitive reasoning, judgments, and/or cognitive abilities.
 People tend to believe that they are smarter and more informed than they
actually are – this view sometimes referred to as the illusion of knowledge
bias.
 Self- attribution bias is a bias in which people take credit for successes and
assign responsibility for failures.
 Overconfidence bias has aspects of both cognitive and emotional errors.
 There are two basic types of overconfidence bias rooted in the illusion of
knowledge: prediction overconfidence and certainty overconfidence.
Overconfidence Bias

Consequence and guidance to detect and overcome

 Underestimate risks and overestimate expected returns.
 Hold poorly diversified portfolios.
 Trade excessively.
 Experience lower returns than those of the market.

 Review trading records, identify winners/losers

 Calculate portfolio performance over 2+ years
 “Don’t confuse brains with a bull market”
 Conduct post investment analysis
Do Investors Trade Too Much?

Odean (1998)
 Do investors trade too much
because they have ‘good signals’ or
they are ‘overconfident’?
 He analyzes the transactions of a
large sample of individual investors in
the US to test this proposition.
 He calculates that the total
transaction cost of a buy and sell is
about 5.9%. Therefore, stocks bought
must outperform those sold by 6% on
average for a trader to "break-even“
 Stocks bought do not yield enough
to cover transaction costs. Stocks
bought underperform those sold!
Trading Is Hazardous to Your Wealth

Barber and Odean (2000)

 They examine whether most
frequent traders are the worst
performers.
 Those who trade more earn
lower returns, consistent with
overconfidence Individual
investors should avoid active
trading!
 The evidence in these studies
lend indirect support to the
overconfidence hypothesis.
Online investors: do the slow die first
Barber and Odean (2002)
 They analyze the trading performance
of BO of 1,607 investors who switched
from trading stocks on the phone to an
online platform.
They find that in the year prior to the
switch investors out-performed the
market by 2%. However, the year after
switching they under-performed the
market by 3%.
These findings are consistent with
investors becoming more overconfident,
due to biased self-attribution, after a
successful year of treading
This makes them switch to an easy
trading environment, stimulates heavier
trading, and leads to worse performance
Q/A Session

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