Investor Biases

Lecture Objectives

• Understand that investors may not act completely rationally when facing complex decisions.
• Learn about the most prevalent behavioral biases that investors may exhibit.
• Discuss some of the consequences of these biases on investor behavior.

Behavioral Biases

• Standard economic and financial theory assumes investors act rationally.
  • Considering all available information.
  • Leading to optimal outcomes.
  • Supporting market efficiency.
• However, it's well documented that investors don't always act rationally when facing complex decisions.
  • They exhibit various behavioral biases.
• Investment professionals may improve economic outcomes by:
  • Understanding and recognizing these biases in themselves and their clients.
  • Adopting strategies to mitigate their impact.

Types of Behavioral Biases

• Behavioral biases come in two forms:
  • Cognitive Errors:
    • Occur due to faulty cognitive reasoning.
    • Can often be corrected or eliminated through better information, education, and advice.
    • Belief perseverance errors: Tendency to cling to one’s previously held beliefs by committing statistical, information-processing, or memory errors.
    • Processing errors: Information may be processed and used illogically or irrationally in financial decision making.
  • Emotional Biases:
    • Harder to correct because they stem from impulses and intuitions rather than conscious calculations.

Conservatism Bias

• A belief perseverance bias where investors maintain prior views or forecasts.
• They inadequately incorporate new, conflicting information.
• As a result, investors may:
  • Maintain or be slow to update a view or forecast regarding asset prices or other financial variables, even when presented with new information
  • Maintain a prior belief rather than deal with the mental stress of updating beliefs given complex data.

Confirmation Bias

• The tendency to look for and notice what confirms prior beliefs.
• To ignore or undervalue whatever contradicts them.
• As a result, investors may:
  • Consider only the positive information about an existing investment while ignoring any negative information.
  • Under-diversify portfolios because they become convinced of the value of a single or few stocks.
  • Hold a disproportionate amount of their investments in their employer’s stock.

Representativeness Bias

• The tendency to classify new information based on past experiences and classifications.
• Base-rate neglect:
  • A phenomenon’s rate of incidence in a larger population (base rate) is neglected in favor of specific information.
• Sample-size neglect:
  • Investors incorrectly assume that small sample sizes are representative of the population.
• As a result, investors may:
  • Adopt a view or a forecast based almost exclusively on individual, specific information or a small sample.

Illusion of Control Bias

• Investors tend to believe they can control or influence outcomes when they cannot.
• As a result, investors may:
  • Inadequately diversify portfolios because they prefer to invest in few companies that they feel they have control over.
  • Trade more frequently than is prudent.
  • Construct financial models and forecasts that are excessively detailed.

Hindsight Bias

• Believing that past events were predictable and reasonable to expect.
• Investors tend to remember their own predictions as more accurate than they were.
• They are biased by knowledge of what actually occurred.
• As a result, investors may:
  • Overestimate the predictability of an investment outcome.
  • Unfairly assess investment performance.

Anchoring and Adjustment Bias

• Relying on an initial piece of information ("anchor") to make subsequent estimates, judgments, and decisions.
• Investors tend to adjust their anchors insufficiently.
• Produce approximations that are consequently biased.
• As a result, investors may:
  • Stick too closely to their original estimates when learning new information.

Mental Accounting Bias

• Mentally dividing money into "accounts" that influence decisions, even though money is fungible.
• Instead of considering their entire portfolio, investors often construct portfolios in a layered pyramid format, with each layer addressing a specific financial goal.
• As a result, investors may:
  • Neglect opportunities to reduce risk by combining assets with low correlations.
  • Irrationally distinguish between returns derived from income and returns derived from capital appreciation.

Framing Bias

• An information-processing bias in which a person answers a question differently based on how it is asked or framed.
• Narrow framing occurs when people evaluate information based on a narrow frame or reference.
• Losing sight of the big picture in favor of one or two specific points.
• As a result, investors may:
  • Misidentify their risk tolerance because of how questions were framed.
  • Focus on short-term price fluctuations, ignoring long-run considerations.

Availability Bias

• An information-processing bias in which investors estimate the probability of an outcome or the importance of a phenomenon based on how easily information is recalled.
• As a result, investors may:
  • Limit their investment opportunity set.
  • Choose an investment or mutual fund based on advertising or the quantity of news coverage.
  • Fail to diversify their portfolio because they make their choice based on a narrow range of experience.

Loss-Aversion Bias

• The tendency to strongly prefer avoiding losses to achieving gains.
• A consequence is the disposition effect:
  • Holding investments in a loss position longer than justified by fundamental analysis, hoping they will return to breakeven.
  • Selling investments in a gain position earlier than justified by fundamental analysis, fearing gains will erode.

Overconfidence Bias

• Investors demonstrate unwarranted faith in their own abilities.
• Self-attribution bias:
  • Investors take too much credit for successes (self-enhancing).
  • Assign responsibility to others for failure (self-protecting).
• As a result, investors may:
  • Underestimate risks and overestimate expected returns.
  • Hold poorly diversified portfolios, resulting in significant downside risk.

Self-Control Bias

• Investors fail to act in pursuit of their long-term goals in favor of short-term satisfaction.
• Lack of self-control may be a consequence of hyperbolic discounting:
  • The tendency to prefer small payoffs now compared with larger payoffs in the future.
• As a result, investors may:
  • Save insufficiently for the future.
  • Borrow excessively to finance current consumption.

Status Quo Bias

• Investors choose to do nothing (maintain the "status quo") instead of making a change, even when change is warranted.
• This behavior is attributed to inertia rather than a conscious choice.
• As a result, investors may:
  • Unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances.
  • Fail to explore other investment opportunities.

Endowment Bias

• Investors value an asset more when they own it than when they do not.
• This is inconsistent with standard economic theory.
• The price a person is willing to pay should equal the price at which they are willing to sell.
• As a result, investors may:
  • Fail to sell certain assets and replace them with other assets.
  • Continue to hold assets only because of familiarity, which may lead to inappropriate asset allocation.

Regret-Aversion Bias

• Investors tend to avoid making decisions out of fear that the decision will turn out poorly.
• Regret is more intense when unfavorable outcomes result from an action taken versus an action not taken.
• As a result, investors may:
  • Be too conservative in their investment choices.
  • Engage in herding behavior, as following popular investments may limit potential future regret.

Additional Resources

• CFA Program Curriculum, 2025, Level I, Volume 9: Portfolio Management
• Learning Module 5: Sections 1-5