The Inherent Bias to Investing

July 16, 2020
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Consumer behavior is human behavior. We’d like to believe that we are rational decision makers who thoroughly evaluate a situation before making a move, but that’s simply untrue. Research spanning decades clearly shows that emotion drives judgment, not logic. In fact, evidence states that when people are presented with evaluating risk-based situations, they often react to the emotional aspects as opposed to the anticipated benefits. 

A fish doesn’t know it lives in water

Investing itself incorporates an intoxicating cocktail of bias: recency, authority and affinity. Recency bias plagues investing because it puts extra emphasis on what’s happening today continuing into the future, causing us to extrapolate inaccurate conclusions. Authority bias is something we’ve seen more recently in the market, with regards to the influx of new investors onto platforms like Robinhood. New investors tend to follow personalities like Dave Portnoy from BarStool Sports and make picks based on his recommendations and actions, perceiving him to be an authority. However, those who have seen his dog and pony show, know that he is hardly an expert in the market. Affinity bias is the desire to associate with people similar to ourselves, and is most commonly present among investors in private groups, such as hedge funds. The exclusivity of the group itself gives credence to the idea that its superior mindset will produce higher than “average” stock picks.

We’ve recently watched herd mentality present itself when crowds rushed to buy worthless Hertz stocks while the company was in bankruptcy, simply because ‘everyone’ else was doing the same. This behavior shows the irrationality of bias and how we’d rather be wrong along with the rest of the crowd, than right and alone. 🤦 

The psychology of human nature

We may be the most advanced mammal on the planet, but we’re rather ineffective at calculating risk, especially when it pertains to the future. People tend to grossly underestimate future-risk and believe that present conditions/data will continue uninterrupted. Considering that the idea of rewards significantly clouds our judgement at assessing risk, this has a profound impact on the stocks we pick. The best way to mitigate this effect, according to Harvard Business Review, is by asking yourself a simple question: What is my winning preventing me from seeing? This question is designed to combat bias and remind us to look at the bigger scope of what we’re trying to accomplish.  

Balancing risk and uncertainty is just about mandatory for a long and successful investment career, in addition to self-awareness to mitigate our worst impulses and remain mindful of how our emotional reactions and cultural conditioning affects our investments. Conditions of uncertainty, like a pandemic, certainly make rational decision making more difficult for people, but it’s necessary to avoid expensive investment mistakes. Now, more than ever, is the time for financial literacy.

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By Kirsten Campbell