latest Content

11 behavioural biases that can affect clients’ decisions

Legal & General Investment Management’s head of multi-asset funds John Roe profiles eleven biases that can influence and, unfortunately, undermine clients’ investment decisions

The impact of behavioural biases can be so strong on investors and their investment decisions, that one country is currently running a study to limit the amount of times pension investors look at their portfolio. This may minimise the impact of just one of these biases (see number 1 below), yet, drawing lessons from behavioural psychological and economics, we can identify a range of investment biases. Increasingly, investment professionals are using this knowledge to design better investment solutions and/or to gain an advantage over the rest of the market.

1. Viewing investing as a series of isolated gambles may make people overly risk averse

We tend to see each risk we take in isolation, rather than a series of calls that may offer favourable odds over the longer term. Viewed collectively as a set of decisions with a very clear potential upside, more people would be willing to take more risk. Unfortunately, we are systematically tempted to take too little risk and, with access to more information, the internet age makes this problem worse. In investment terms, particularly for the average, albeit engaged investor, the more frequently they look at their portfolio, the more they may focus on the risks. Also the more they see short-term, isolated events it will lead to too little risk being taken over a period of time.

2. Gains are worth less than losses at least in investors’ minds

Would you rather win £10m and then lose £9m or win £1m without any of the stress of those nasty losses? Conventional economics would see little difference applying something called the utility curve but bluntly people don’t think in terms of utility. Indeed, it could suggest that this key element of economics is fatally flawed. We find something called ‘prospect theory’ much more applicable to the real world of investing, which means that what people start out with or indeed gain along the way, has much more bearing on their behaviour and decisions. So if they build up a significant gain, but then lose much but not all of it, they won’t remember that they are still better off. It is bit like the CNN owner Ted Turner actually in tears on television after the tech bust because he was no longer a multi-billionaire though he was, nevertheless, still a billionaire.

In terms of investment psychology, gains are worth less than losses even gains and losses of exactly the same magnitude. This means the smoothing of gains and losses has value for investors. Indeed, research suggests that investors would be prepared to give up gains in advance just to have a smoother investment ride with less volatility, even if they know they are not going to sell for several years.

3. The frame they place on something is an important influence on a decision – framing can fool us all

It is possible to influence someone’s decision by the way you group options together. Even offering an option as the middle one in a group of three biases the decision. More people tend to choose the middle options. People are also more likely to choose a light colour over a dark one and a star over a triangle. Framing fools us all, and the way options are presented can certainly create bias towards one over another. Using these principles, in three independent tests we convinced over half the participants to choose a single shape out of four options, despite them being asked to choose randomly; not so long ago, similar tricks were passed off as magic on television shows. It is worth bearing in mind, when extolling a number of ‘excellent investment opportunities’, that we may be favouring one simply as a result of our own biases.

4. Once anchored to an initial value, people never adjust enough when making decisions

This behaviour may not have required a psychology lab to discover; a visit to a souk to barter for a carpet might have told as much. But it is still pretty clever. If you furnish an investor with a low percentage as an anchor of say 10% and then ask them to provide an answer to a question, even if the answer might be 90% or 100%, most people will come in way under. They never adjust enough from the initial value you offered them. The first value given has ‘anchored’ the subsequent answer. Investors given more information may adjust it up but it is not likely to be far enough. So if they read the FT in the morning, and it is full of positive stories, they may be excessively positive all day. This bias has been shown to work even if participants know the anchor is completely unrelated to the follow up question, for example if the anchor is just a randomly generated number.

5. Issues that are being widely discussed and information that is more easily available will have more influence on decisions

A useful exercise here involves considering the ratio of words in English which start with an ‘R’, say Rabbit, to those words with ‘R’ as the third letter, so, say caR. Most people will overstate the Ratio as thRee to one. It is actually one to one. That is because we Remember moRe woRds that start with R than Recognise those woRds which have it as a third letter. This also applies to stories that are in the news. If the prevailing atmosphere in the media is fearful, then that will influence decisions but they may not be the right ones.

6. Don’t neglect the ‘base rate’ – people tend to think they can beat the odds

Ask a room of investment professionals about their skills in picking a fund or a stock (you may have been in such a room recently) and you may find that 75% will say they are better than average. But only 50% can be better in terms of a large audience at least. This is known as base rate neglect. In the real world, it means that those brave chefs/entrepreneurs who set up a restaurant generally believe they have a high chance of succeeding, when sadly over half close in the first year. The catering trade is a tough business so maybe it’s better to stick to markets but be aware of that over-confidence in yourself and others.

7. The endowment effect – or what you own you (over) value

If you offer someone a gift, say a free mug or a fascinating book about behavioural economics and get them to value it, they will generally put a higher price on it, than someone who does not own it. This is called the endowment affect. It is one of the reasons people won’t decide to sell all their investments, start with a blank piece of paper and start again. For example long term investors in oil production companies may have had a difficult time adjusting to the recent share prices, though they also need to consider whether selling is crystallising their losses, hopefully considering all of the biases discussed here.

8. Status quo bias or anything for a quiet life

It is within the power of all us to do nothing. We prefer not to change. This basically works on the premise that not making an alternative decision is less painful than choosing a new option and is all to do with prospect theory (discussed in point 2 above). You start from your current position, so you view anything you lose by selling a share as a loss and any gains from moving as a gain. You might say this evens out, but because you overweight losses to gains in your head, you are less likely to sell – hence the status quo bias.

9. Confirmation bias

Once people make a decision they don’t like changing it. They believe they are right and have overconfidence about it. Therefore new and useful information, which doesn’t agree with someone’s current thesis, will often be discounted while less useful information may be used to confirm existing views. Investors do this all the time. Once they have received new information that doesn’t confirm their thesis, they may fail to process it properly.

10. Recency bias or attaching too much importance to what has just happened

They generally find that after markets have fallen, people get negative and that after markets have risen people get more positive. There is a correlation between the ownership of equities and their recent performance. This is a problem because it is an example of recency bias. At worst it means people buying at or near the top of the market and selling at or near the bottom. Not a formula for success.

11. Egocentric bias, or believing you are immune to many of these biases

Do you think you are more or less influenced than the average person? Many people believe they are less influenced. This is egocentric bias. In a similar vein, it is much easier to remember your own performance than it is other people’s performance. So people will tend to remember their investment wins over their investment losses. They will tend to over-estimate the positive impact in any joint decision-making. Other people think this way too, but understanding this can help make you a better investor, though I would suggest you don’t get too egotistical about it.

Subscribe now large banner advert White on red

More Articles Like This