Endowment Bias 

Endowment bias can be thought of as “falling in love with an investment” in other words getting too emotionally attached. This investment may have performed fantastically well for you in the past and now you find yourself reluctant to sell any of it. Of course, this could be for perfectly rational reasons – the investment could be stock in a company that is a long-term winner in its industry and that is still blessed with tailwinds that support further growth. However, it may be an investment that, although it has performed admirably in the past, maybe past its best and it could be time to reallocate the capital tied up in the investment to more promising opportunities.

Potential solution: To prevent endowment bias from clouding your investment decisions, it can be worth asking yourself “does this investment still offer compelling opportunities for future growth, and, if I didn’t already own it, would I buy it today?” If the investment has grown to a sizeable proportion of your total portfolio, it is also worth asking “how would I cope if this investment were to suffer a large decline in value?”   It is important to note that not all investors will be susceptible to exactly the same biases. We are all perfect (and imperfect) in our own special way! You are the best judge to identify which biases have the better of you. Recognize these biases when you are exhibiting them and deliberately make an attempt so they do not cloud your investment judgment.  

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Loss Aversion 

Loss aversion may be the most common investment bias of all, particularly among newer investors (though even highly experienced investors can fall foul of this bias). Loss aversion arises as a result of the human tendency to feel the pain of a loss more acutely than the pleasure of an equivalent gain. In practice, this results in investors refusing to sell out of investments that have fallen in value, even if the fundamentals have changed, in the hope that, somehow, the investment will return to its original purchase price and they can sell out at breakeven. Another effect of loss aversion is that, as soon as an investment makes a small gain (say 10%), the investor will sell out to capture this small gain and, thereby, avoid the pain of a potential loss. In a nutshell, then, loss aversion can cause investors to run their losers and cut their winners, a terrible strategy for long-term wealth accumulation.

Potential solution: If an investor struggles with loss aversion, they should define a maximum loss they are prepared to take on the investment and either resolve to sell the investment if it falls to the price representing their maximum loss level or, better still, set a stop loss at this price level to take all the emotion out of the selling decision. Another way to deal with loss aversion is to look critically at investments that have fallen in value and ask yourself “are the reasons for my original investment still valid and if I didn’t already own this investment, would I still be happy to buy it today?”. 

It is important to note that not all investors will be susceptible to exactly the same biases. We are all perfect (and imperfect) in our own special way! You are the best judge to identify which biases have the better of you. Recognize these biases when you are exhibiting them and deliberately make an attempt so they do not cloud your investment judgment.  

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Anchoring 

Anchoring occurs when investors become fixated on a particular number, such as the price at which they bought into a particular stock or a price target that they hope the stock will reach. Anchoring can prevent an investor from selling out if the fundamentals change for the worse, holding on with dogged determination to try to get back to the breakeven point or from selling out of a currently profitable investment that probably doesn’t have too much further to go, simply because it hasn’t quite reached a particular target price. Anchoring may impose actual losses upon investors due to holding onto a sub-optimal investment for too long or subject them to opportunity costs, as they either don’t realize cash from existing investments that could be rolled into more promising opportunities or they don’t get into promising opportunities in the first place because the price of these opportunities never quite falls to an unrealistically low level that the investor is anchored to.

Potential solution: To avoid anchoring, investors should regularly review any price targets that they have for their investments or potential investments and ask themselves “is this price target reasonable based on rational analysis of the opportunity or am I irrationally anchoring on a particular price based on past experience or unjustified expectations?”      

It is important to note that not all investors will be susceptible to exactly the same biases. We are all perfect (and imperfect) in our own special way! You are the best judge to identify which biases have the better of you. Recognize these biases when you are exhibiting them and deliberately make an attempt so they do not cloud your investment judgment.  

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Representativeness Bias 

Representativeness bias is exhibited when investors attach too great a weight to particular data points. For example, investors may assume that current trends in an industry that is inherently cyclical will remain in place indefinitely just because they have been in place in recent years or investors may assume that the results of a study involving a small sample will be representative of a much larger population.

Potential solution: To avoid falling victim to representativeness bias, investors should try to be mindful of probabilities and historical norms before extrapolating current assumed trends far out into the future.  

It is important to note that not all investors will be susceptible to exactly the same biases. We are all perfect (and imperfect) in our own special way! You are the best judge to identify which biases have the better of you. Recognize these biases when you are exhibiting them and deliberately make an attempt so they do not cloud your investment judgment.  

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As humans, each of us has subconscious biases. These biases create blind spots and errors, costing us real cash. Perhaps we cannot completely eliminate our biases but we can work towards recognizing, acknowledging, learning, and ultimately reducing them. If done successfully, we will improve our decision-making and financial results.

Confirmation Bias 

Confirmation bias is the tendency for investors to actively seek out information that supports their preconceived views while totally ignoring any (and even all) contradictory information. For example, an investor may have purchased shares in a company in anticipation of the launch of an exciting new product and will avidly read any articles they can find on the benefits of this new product. However, they will actively ignore any articles on topics such as the strength of competitors’ products or potential delays or technical difficulties associated with the product launch. This “blinkers on” approach can lead to the incorrect assessment of downside risk and ultimately loss of capital.

Potential solution: Deliberately seek out information that challenges your original investment and/or discuss your views with trusted friends who have views that do not exactly agree with yours. Your open-mindedness and ability to assimilate new information objectively and dispassionately should do wonders to your bank balance.  

It is important to note that not all investors will be susceptible to exactly the same biases. We are all perfect (and imperfect) in our own special way! You are the best judge to identify which biases have the better of you. Recognize these biases when you are exhibiting them and deliberately make an attempt so they do not cloud your investment judgment.  

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