The mental roadblocks humans tend to throw in front of their efforts to make sound decisions have come to be known as “cognitive biases.” Cognitive biases are so apparent and so inherent that there’s no disputing their existence.
Psychological research has identified an array of cognitive biases. Given the foundational level at which these biases exist, they have the capacity to affect practically all decisions, but can have an especially profound impact on financial planning and investment choices. What follows is a look at seven cognitive biases that exert influence over financial decision-making. You likely will recognize each as existing, to one degree or another, within yourself.
Overconfidence bias. Possessing an inflated view of one’s own decision-making abilities is a brief way to define overconfidence bias. Affected investors tend to overestimate personal abilities, which can prompt them to make wrong-headed — and ultimately harmful — investment decisions. In fact, one revealing piece of research concluded the most active investors may realize the poorest results precisely because of overconfidence bias.
The study, authored by University of California system professors Terry Odean and Brad Barber, found that, among retail brokerage account owners, the most active investors posted the lowest returns. Odean and Barber suggest, as well, that overconfidence bias is facilitated by a component condition known as self-attribution bias. Individuals with self-attribution bias have a greater tendency to see positive outcomes as functions of their skills and abilities, and negative outcomes as the result of bad luck. Self-attribution bias can block negative internal feedback about low returns, making it more challenging for investors to improve their financial decision-making abilities.
Confirmation bias. Confirmation bias represents another destructive influence on investors. Confirmation bias, as it pertains to portfolio management, prompts one to prioritize information about an investment that agrees with one’s existing ideas and beliefs over information that does not so agree.
It is reasonable to assume that investors who adhere to certain investment “schools of thought” or devotees of select asset classes can be particularly prone to confirmation bias. For example, the “gold bug” who insists on investing predominantly in precious metals will often derive validation from select news reports suggesting higher prices for gold in the near term, while dismissing more prominent elements of the investment environment indicating lower prices for gold.
Whether evaluating specific securities or entire asset classes, investors are best-served by remaining “agnostic” as much as possible. For many people, however, the natural tendency toward confirmation bias can make that a distinct challenge.
Familiarity bias. Familiarity bias is rooted in the idea that people tend to derive greater comfort and confidence from those things with which they’re most familiar. It’s such a basic behavioral tenet that it really needs no explanation; people maintain closer relationships with those they know best, while keeping strangers at arm’s length.
However, while familiarity bias may offer some advantages in the realm of human interaction, it can be problematic for investors. Familiarity bias can prompt individuals to perpetually gravitate toward markets and vehicles well-known to them, at the expense of less-familiar options that may nevertheless be superior. The upshot of familiarity bias is that it can leave investors vulnerable to subpar portfolio returns.
Familiarity bias manifests in a variety of ways, and at a multitude of levels. One example is the 401(k) plan investor who invests only in company stock simply because it’s the portfolio option they know the best. Familiarity bias can discourage investors from pursuing viable opportunities in markets, asset classes, sectors, etc., in which they aren’t well-versed. As a result, familiarity bias may discourage asset allocation and effective diversification, both of which can help a portfolio minimize risk over the long term.
Endowment effect. Endowment effect refers to the behavior of ascribing greater value to something simply because you already own it. One of the most common examples of endowment effect can be found in the realm of real estate. Agents will tell you that sellers frequently wish to see their properties listed for a sum much higher than that which is suggested by the prevailing market — that’s a textbook example of endowment effect. A frequent consequence of endowment effect in that setting is a stale property listing that ultimately expires. When such a houses does eventually sell, it is often for even less than the agent’s initial target price.
Endowment effect is evident in securities investing, as well. There, investors have a tendency to evaluate their holdings with a benevolent eye, which frequently encourages them to hang on to a stock or fund long after objective analysis advises selling it. Hence, one of the additional consequences of endowment effect is opportunity cost, which refers to the lost opportunity to put that money to work in an investment with better prospects. Endowment effect, therefore, has the potential to be very destructive to a portfolio’s overall performance.