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Behavioral Biases and Cognitive Errors: An Introduction for Investors

By Evan Jones, CFA®September 6, 2019Investing

A 2017 study conducted by market research firm Dalbar reported that over a 30 year period the S&P 500 annualized returns of about 10.2%, while individual equity fund investors annualized only 3.98%. How do you explain this disparity when everyone knows that you’re supposed to invest for the long term? The fields of Finance and Economics are great at explaining large scale processes mechanistically, but have always struggled to account for investor behavior at the individual level. One of the possible culprits is that Finance and Economics have traditionally used what’s called the “Rational Man Theory” to explain investor behavior. Under this framework it is assumed that investors examine all available information and process that information totally rationally. This framework makes sense only to say how investors should behave, but falls short when trying to explain how investors do behave. Knowing this, it then becomes obvious that traditional financial theory could use some help bridging the gap between should and do. This is where Behavioral Finance really shines. Starting in the 1980s and borrowing heavily from Psychology, Behavioral Finance defines a set of cognitive errors that help explain many of the sub-optimal decisions investors commonly make. Cognitive errors fall under three sub-categories: Belief Perseverance, Information Processing, and Emotional Biases.

Belief Perseverance Biases are characterized by a difficulty assimilating new information that conflicts with already held beliefs. Many types of belief perseverance biases have been identified such as: Conservatism, Confirmation, and Representativeness Bias. One of the most familiar is Hindsight Bias, which is the tendency to see past events as being more predictable than they really were at the time. Investors fall into this mode of thinking simply because events that did occur are much more evident that those that did not occur.

An example: Joe Smith bought XYZ stock a couple years ago, and it’s recently skyrocketed 80% for unforeseen reasons. Joe doesn’t fully remember his original investment thesis for XYZ, so he mentally rewrites history taking credit for a very successful stock pick. Even though Joe has a great result with XYZ stock, his hindsight bias could lead him to become overconfident and to take excessive risk in the future.

Avoiding hindsight bias is one of many good reasons for investors to maintain a meticulous record of their investment decisions (both good and bad). Having a recorded investment thesis could have prevented Joe Smith from rewriting history.

Information Processing Biases are about absorbing new information irrationally. They differ from belief perseverance biases because previously held beliefs do not play as much of a role. A good example is known as Framing Bias. Framing bias occurs when investors act differently based on how information is presented.

An example: Many investors have had the experience of completing a risk tolerance questionnaire. Take these two questions as an example.

Question 1:
Based on the information below, which investment do you favor?

InvestmentReturn RangeAverage Return
A1% to 6.5%3.5%
B-14% to 24%7%
C-24% to 38%12%

Question 2:
Based on the information below, which investment do you favor?

InvestmentAverage ReturnStandard Deviation

These two questions frame risk in different ways, so it is likely that an investor’s choice is dependent on which question they are given. As a result, investors could end up choosing an investment portfolio that is out of alignment with their real goals. A way to avoid this is to ask yourself if your choice is based on positive/negative wording or the actual future prospects of the investment. This problem of positive and negative framing also supports the case for working with a trusted advisor that knows more about you than just a questionnaire.

Emotional Biases are based on feeling rather than rationality. A classic example of emotional bias is the phenomenon of loss aversion. It has been found in numerous studies that investors feel the pain of losses much more acutely than the pleasure of gains. The graph below illustrates this. The x-axis represents Gain/Loss and the y-axis represents the positive or negative value perceived. As you can see, a $.05 gain provides about +16 in value perceived, where a -$.05 loss results in a much greater negative perception of -40.

Unlike belief perseverance and information processing errors, which are both faults in rationality, emotional biases are harder to avoid or correct. However, a well defined investment strategy focused on fundamental analysis can help investors avoid emotional investment decisions.

This quick overview of the broad categories of behavioral biases (Belief Perseverance, Information Processing, and Emotional Bias) only scratches the surface on the topic. There are many more biases that we will cover in the future like: Status Quo, Endowment Effect, Illusion of Control, and Anchoring. Until next time, stay rational out there…

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