Recognizing Your Behavioral Biases

We like to think we’re rational human beings. But, the truth is we all have biases that influence the way we see the world and make decisions about people, politics, opportunities, and, of course, investing. In fact, we’re prone to a host of cognitive and emotional biases that cause us to think and act irrationally – often leading to flawed conclusions and less than optimal investing decisions.

WHAT ARE COGNITIVE BIASES?

There are well over 100 cognitive biases, an umbrella term that refers to types of errors in thinking that occur when we’re processing and interpreting information. Think of them as mental shortcuts that help us make sense of the world and reach decisions quickly. If we had to consider every possible option and outcome when making a decision, we would likely be overwhelmed. Because of the amount of information we’re exposed to, it’s necessary to rely on mental shortcuts that allow us to act quickly.

Because of the complexity of the markets and our nonstop access to data, investors tend to rely on cognitive biases more than they should to make important decisions, like when to buy and sell and how to manage risk. Confirmation bias, which is our tendency to ignore information that challenges or contradicts our views and opinions, is exhibited repeatedly in the investment world. Anchoring, where we continue to use information we’ve used to make past decisions despite the existence and availability of new and relevant data, is another.

WHAT ARE EMOTIONAL BIASES?

As its names suggests, emotional biases stem from emotional factors, like impulse or intuition, which distort cognition and decision-making. The effects of emotional biases can be similar to cognitive biases and can even be considered as a subcategory of those biases. The differentiator, however, is that the cause lies in our fears and/or desires, rather than our reasoning.

Like cognitive biases, investors are prone to use emotional biases to make important investment decisions. Loss aversion, for example, which is our tendency to feel the pain of loss more profoundly than the joy of an equivalent gain, can lead investors to hold on to losing assets longer than they should to avoid the pain of seeing a loss materialized, which only exacerbates losses more. And, the status quo bias can prevent investors from making changes that may be beneficial. For instance, studies show that many investors don’t make changes to their retirement savings allocations over time – which can result in a portfolio that’s riskier than it should be given their proximity to retirement.

OVERCOMING OUR BIASES

Recognizing that we all rely on biases to make decisions is the first step to overcoming them – or, at least trying. While it’s nearly impossible for us to be completely unbiased in our investment decisions, we can lessen the impact by identifying the cognitive and emotional biases we’re more apt to fall back on, and actively working to outsmart our brains and temper our emotions to achieve better outcomes.

Here are a few of the most common cognitive and emotional biases that can derail investors’ long-term objectives:

Cognitive Biases

Confirmation Bias

What is it?

People tend to look for, and notice, evidence that confirms their existing beliefs, ignoring other information that challenges or contradicts their views. This happens as human beings tend to avoid what is technically called “cognitive dissonance” – the mental discomfort that occurs when new information conflicts with our beliefs or perceptions.

What are the effects on investors?

In the investment world, confirmation bias is exhibited repeatedly. As a result, investors ignore negative information about certain assets, which could be a warning sign that can help prevent losses. Investors may also ignore information that supports differing points of view, which can make them miss out on attractive opportunities.

Anchoring Bias

What is it?

Anchoring is the tendency to rely too heavily on the first piece of information we learn, which can have a serious impact on the decisions we make. Once that first piece of information, or “anchor,” is set, our brain makes adjustments based on that anchor.

What are the effects on investors?

Investors may stick too closely to their original estimates when new information becomes available. For example, if an investor estimates next year’s earnings for a company to be $2 per share and the company experiences difficulties during the year, the investor may not adjust their original estimate to account for these challenges because they’re anchored by their original estimate.

Narrative Bias

What is it?

The narrative bias refers to our tendency to interpret information as being part of a larger story or pattern, regardless of whether the facts actually support the full narrative.

What are the effects on investors?

Investors are likely to abandon evidence in favor of a good story about a specific stock or strategy. For example, the most admired stocks have the greatest stories, but they also tend to have the highest prices. While stories can be compelling, it’s important to consider the whole picture before making an investment decision.

Emotional Biases

Overconfidence Bias

What is it?

This bias occurs when people overestimate their own abilities, believing that they are smarter or more informed than they really are. People showing overconfidence may mistakenly equate information quantity with quality, feeling more confident if they have substantial amounts of information, even if its quality is poor.

What are the effects on investors?

Overconfident investors tend to underestimate the risks or overestimate the expected returns of an investment. They also tend to trade excessively – quick to sell an asset that has disappointed them, only to buy a new security that they feel overconfident about. And they do it repeatedly.

Status Quo Biases

What is it?

Status quo bias is an emotional bias in which people respond to new circumstances by doing nothing instead of making appropriate adaptations. People are generally more comfortable keeping things as they are. This bias might prevent an investor from looking for opportunities where change may be beneficial.

What are the effects on investors?

Investors unwilling to change or adapt to new information may end up with portfolios that are inappropriate given their circumstances, perhaps making an old investment no longer suitable as markets shift.

Endowment Effect

What is it?

The endowment effect makes investors give holdings that they own a disproportionate value simply because they already own them. If the endowment bias didn’t exist, the price that people would be willing to buy would equal the price at which they would be willing to sell – something that rarely happens.

What are the effects on investors?

Investors may hold on to losing or inappropriate assets, instead of selling them, because they are assigning them a disproportionate value. This focus also makes investors miss out on other, perhaps better, opportunities.

BEHAVIORAL SCIENCE IN ACTION

PIMCO has long understood that behavioral science can make us better investors. That’s why we’ve partnered with some of the best minds in the field at the Center for Decision Research at The University of Chicago Booth School of Business. Through this innovative partnership, PIMCO supports diverse and robust academic research that contributes to a deeper understanding of human behavior and decision-making. Learn more about how behavioral science can make you a better investor.

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