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