Biases come from systematically preferring one outcome over another. Investor biases may result from a number of mental models and heuristics. Faulty reasoning, emotional biases, perception biases, and other psychological or behavioral issues influence investment decisions and may lead to poor decision making.
Frame dependence is a belief perseverance cognitive bias where a question is answered differently based on how the question is framed. Frame dependence may result in investors focusing on changes in wealth as opposed to levels of wealth, causing them to make inconsistent decisions. The way a situation is framed has a significant impact on the decision-making process.
For example, framing an investment with the potential for a gain versus framing an investment with the potential for a loss, although the expected outcomes are the same based on probabilities, is a frame dependence bias. Another example of frame dependence deals with opt-in and opt-out options. Although the end result is the same, the way in which the scenario is framed results in different participant behavior.
The willingness of an investor to accept risk may be influenced by the way the investment is presented.
Confirmation bias is a belief perseverance bias where investors overemphasize information that confirms their beliefs and ignore, avoid, or underweight views that conflict with previously held beliefs. Confirmation bias occurs when investors tend to agree with or actively seek out information and viewpoints that support their perspective and ignore or avoid new information that refutes or contradicts their beliefs.
Under-diversification or overconfidence may result from confirmation bias, as compatible information is more likely to influence an investor’s decision making. This may lead to increased capital allocation in poor investments and/or an unwillingness to exit losing positions.
Mental accounting and house money
Mental accounting is an information processing cognitive bias where investors separate money into different mental categories depending on the source of the funds. Equal sums of money are viewed differently depending on which “mental bucket” the money is assigned to.
For example, someone may be inclined to spend money from a paycheck differently than money received in a tax return or invest for retirement conservatively but take more risk in a separate account where they feel that losing money is acceptable.
Under mental accounting and house money, funds earned from income are viewed differently from returns earned through capital appreciation, and the source of the funds may influence subsequent investment decisions. “House money,” such as unrealized gains in an account, may be viewed as an expendable resource, and investors may be more inclined to take larger risks with the money.
Loss aversion is an emotional bias originating from prospect theory. With loss aversion, investors avoid risk to the point where they will not exit a losing position and realize a loss, because doing so will make the loss an actualized reality with a subsequent financial impact.
Loss aversion moves beyond risk-averse behavior to the point where an investor no longer acts rationally when considering investment losses. The reluctance to sell an investment that has declined in value, and accept the loss in the account, outweighs the sound decision of taking the loss, despite indications it may be the prudent decision.
Anchoring is an information processing behavioral bias where investors anchor an investment’s value to the price they originally paid for the security instead of its current value. Any subsequent information received after the purchase is weighed in relation to the anchored price.
Anchoring is also called the break-even effect or disposition effect. The investor attaches emotion to a specific price, therefore mentally anchoring the investment’s value to this price and disregarding changes in the market or security that may impact that value. This anchor may be the purchase price or some expected future value.
Conservatism bias is a belief perseverance bias where investors maintain previously held views at the expense of new information received. Investors overemphasize their initial beliefs and discount new information.
Conservatism bias prohibits investors from updating models or forecasts. Instead, investors tend to rely on the initial information that guided their decision-making process, despite newer, more relevant data being available.
Sunk cost fallacy
Sunk cost fallacy is a behavioral bias where investors commit more capital to investments that have declined in value to lower the break-even point, regardless of the investment’s prospects going forward. Sunk cost fallacy causes biased decision making due to regret over previously committed funds.
Sunk cost fallacy builds on anchoring bias and loss aversion and an investor’s belief that they were right in their original decision-making process and a security's price must eventually come back around.
The endowment effect is an emotional bias where investors attribute more value to an investment currently owned than if they did not own it. Investors may become overly optimistic about an investment’s future returns and ignore contradictory information that may suggest otherwise.
For example, an investor might seek a higher exit price for an investment than he or she would be willing to pay to purchase the investment, simply because the investor owns the asset. The endowment effect essentially “endows” an asset with added value because the investor owns it and may cause investors to hold sectors or assets they are more familiar with.
Overconfidence is a behavioral bias where investors attribute higher levels of knowledge or skill to themselves than they actually possess and likely overtrade or underestimate risk as a result.
For example, many individuals believe they are above-average drivers in the same way they believe they are above-average investors. The overconfidence then leads to potentially detrimental behaviors such as overtrading or lack of diversification.
Illusion of knowledge
Illusion of knowledge is a behavioral bias that results from overconfidence, where the belief that information held by the investor is superior to the information of others. Because of this illusion of knowledge, investors under-diversify or believe that an investment holds value regardless of what most market participants believe.
The snakebite effect is a behavioral bias that is the opposite of overconfidence, where a series of losses leads to the belief that the investment process has failed, and an investor is unable to do anything right. The snakebite effect may lead to irrational decisions, such as prematurely giving up on an investment or portfolio manager or being afraid to enter trades in the future for fear of losing again.
Hot hand fallacy
The hot-hand fallacy is a bias where a streak of winning trades skews the perceived odds of an investor’s success. For example, after a series of wins, an investor may perceive the odds of a 50/50 outcome as better than 50/50.
The hot-hand fallacy is an overconfidence bias that may result in over-allocating funds to a marginal investment or neglecting proper risk management practices after a series of successes.
Clustering illusion occurs when a group of random outcomes leads to the belief that the results are not, in fact, random. For example, when flipping a coin, if a series of heads appear consecutively, the likelihood of another heads is perceived to be higher.
Suppose an investment has a 60% likelihood of success, but 5 of the last 5 investments resulted in a gain. In that case, the investor may wrongly believe the investment has a higher than 60% likelihood of success.
The gambler’s fallacy occurs when an investor assumes that a deviation from a historical average will be immediately corrected. For example, suppose an investment has a 60% likelihood of success and 5 of the last 5 investments resulted in a loss. In that case, the likelihood of success for the next investment is higher than 60% because of the previous losses.
Law of small numbers
The law of small numbers is a cognitive error where investors believe that the probability exhibited over a small sample size can be extrapolated to a larger number of samples. The law of small numbers is related to recency bias and gambler’s fallacy and overemphasizes recent outcomes.
Law of small numbers can be found in a sequence of returns. For example, an investor may begin a strategy and experience five consecutive winning trades. The law of small numbers may incorrectly lead them to believe that the strategy is now better than its historical average.
Recency bias is a cognitive error where investors overemphasize recent outcomes. Recency bias results in investors giving more importance to recent events than historical events.
Recency bias may have a similar negative effect as the law of small numbers, as recent events or patterns are extrapolated to make future projections or proper asset allocation is ignored because of recent results.
Hindsight bias is a belief perseverance bias where investors believe past events were predictable or reasonable to expect. Investors may incorrectly recall their past predictions as being more accurate than they actually were and overestimate their ability to predict future events, resulting in overconfidence or reduced risk management practices.
Self-attribution bias is a cognitive error where investors attribute wins to investment skill and losses to poor luck. Self-attribution bias may also be called self-serving attribution bias, which causes investors to blame others for their failures while personally taking credit for successes.
Taking too much risk after a series of successes or holding under-diversified portfolios may result from self-attribution bias.
Fear-of-missing-out, or FOMO, is a cognitive bias similar to herding behavior. The fear of missing out on an investment that could potentially make money causes investors to make suboptimal decisions.
FOMO may be influenced by outside agencies, such as the news or social media, where other investors publicize their successes and investment advice. As a result, investors that do not want to be “left behind” may have an emotional response that forces them outside of their normal investment decision-making process. An investor may be influenced to prematurely enter positions outside of their defined strategy or hold existing positions longer than they intended.