Mar 12, 2021

Bias busting - avoid the pitfalls of behavioural investing

By shaping our perceptions, feelings and the way we process information, biases can result in irrational decisions and may have bigger impacts on your long-term financial success than the actual market itself.

Being in the wealth management business for the past 25 years has given me the opportunity to guide people through all sorts of market conditions, including the current COVID-19 crisis. I’ve witnessed the way people behave and react – or don’t react – to changing market conditions, and have found that this tends to have a bigger impact on their long-term financial success than whatever the markets are doing.

 

Personal bias has long been shown to play an important role in people’s thinking and investment decisions. So what are some common biases, and how can you try to ensure they’re not impeding your portfolio performance?


Cognitive vs emotional biases

The basics of bias

From an investing standpoint, we can think of personal bias as simply favouring one decision over another. We can further break biases down into two distinct types: emotional and cognitive. Emotional biases relate to feelings, perceptions and the relationships between things. They originate from impulses or intuition. Cognitive biases, on the other hand, originate from how we process information or what our memory tells us. What’s important is that both emotional and cognitive biases can result in irrational decisions, which may have a sizeable impact on your investing success.

 

The field of behavioural finance covers many types of bias but I’m going to highlight what I feel are the five most influential ones (based on what I’ve seen play out in my career so far), and offer some strategies to help you identify and correct them. Hopefully, this will help you determine whether you have any of these biases yourself, so that you can guard against the risks they pose.


Five common biases

  1. Loss Aversion (emotional bias) – A person with loss aversion prefers to avoid losses, rather than pursue opportunities offering similar or greater value gains.

    I’ve seen this most often when beginning to work with a new client who has transferred an existing portfolio to our firm, which contains investments that are trading far below what they originally paid for them. Even after discussing the outlook of the investment(s) and other better risk/reward opportunities, the client is reluctant to sell. This is a good indication that they have loss aversion bias.

  2. Status Quo (emotional bias) – When facing a variety of options, a person with status quo bias will typically choose to keep things the same.

    I’ve had numerous discovery meetings over the years with people whose approach to investing was misaligned with their long-term goals. Even when presented with ideas that included opportunities to reduce their portfolio risk, enhance their probability of improved performance, and improve their tax efficiencies, they chose not to make any changes and kept with their original path – or status quo.

  3. Recency (cognitive bias) – When a person extrapolates future returns based on recent returns.

    A great example of recency bias can be seen in the cannabis sector. In October 2015, three years before the legalization of marijuana, Canopy Growth (WEED) stock was trading around $2.00 per share. In October 2018, when Canada legalized marijuana, the stock ran up to over $70 per share – that’s 3,400% in three years! Then, just two months later, the stock dropped by 50%.

    People investing in WEED for the first time at the $60-$70 per share range, prior to the drop, may have had their decision influenced by recency bias, believing that the strong stock performance at the time would continue.

    A more recent example is Tesla. The performance of this stock has been nothing but spectacular. In fact, the stock was up 743% in 2020, with more than half of that return occurring in the last two months of the year. However, one wonders how many investors bought the stock in late 2020 or January of 2021. These people may have been influenced by recency bias. Interesting to note that since reaching its all time high on January 25, 2021, the stock is down 32% (as of March 5, 2021).

  4. Ambiguity Aversion (cognitive bias) – A person prefers taking known risk versus unknown risk.

    This commonly shows up with people who work in a particular sector. Take energy for example. A person working in that sector may feel there are more known risks in this area because of their industry knowledge or comfort level versus, say, the healthcare sector, where they may have less sector knowledge or understanding and, therefore, more unknown risks. While they may be presented with insights to suggest the healthcare sector is likely to perform better than the energy sector, they would probably choose to stay invested in energy over healthcare.

  5. Conservatism (cognitive bias) – When a person stays with a prior view, even when offered new information.

    COVID-19’s impact on the economy and stock market has been challenging for those who have conservatism bias. In the early stages of the pandemic, the global economies collapsed because of the massive shutdowns of businesses and services. As governments and central banks around the world provided liquidity and support and businesses adapted, global economies rebounded along with many company earnings for the remainder of 2020 and into 2021.

    However, those with conservatism bias may have held onto previous beliefs about the impact of COVID-19 on the economy and markets, despite the changing data and facts as time went on. Such people would have remained guarded and defensive, which would have left them out of one the greatest market recoveries of all time.

 

Dealing with your biases
We all have biases, myself included. The first step is to take an honest assessment of yourself and identify which biases you have. Awareness is probably the most important thing when it comes to managing the risks biases can play on your investment success.
The second step is to look at your personal wealth situation and consider if, and how, these biases could be affecting your current or future financial well-being. Should you adapt (accept/ adjust), or modify (reduce/eliminate) the bias?

 

For example, let’s look at two investors, each with $1,000,000 in their investment portfolios. Both are considering investing in Bitcoin for the first time because of the recent performance (that’s correct - recency bias!). The first person is considering a $5,000 investment, while the second is considering a $200,000 investment. All things being equal, if Bitcoin turns out to be a poor decision and drops significantly, it would marginally affect the first person’s well-being, yet significantly impact the well-being of the second person.

 

So in the case of the first person, their bias can be adapted, whereas for the second person, their bias should be modified. Personally adapting and modifying biases on your own can be very challenging, which leads me to the third and final step.

 

Get objective input from a financial expert. Most investment professionals have training, education and experience in behavioral finance and their counsel can prove invaluable in volatile markets. The more open you are with your advisor, the better the portfolio strategy can be designed to help you achieve your long-term goals, and reduce your risk.

 

We all have biases, so don’t be hard on yourself. The key is to be aware of them and make sure they don’t get the better of you.