29 March 2024

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5 behavioral biases and investment decisions

Luigi Campopiano

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"The measure of intelligence is the ability to change when necessary" (quote by Einstein), but in everyday life, we often struggle to objectively judge what is happening to us, being immersed in biases without even realizing it. This poses a significant problem when it comes to financial performance, as it can lead to distortions in investors' decisions. Recognizing behavioral biases, especially the most common ones, is not easy. Here are some according to Legal & General Investment Management (LGIM):

• Confirmation bias (be careful not to trust too much in your own beliefs). It's natural for individuals to have acquired beliefs and take them as a reference point. This means that even in situations far from what one is accustomed to, there is a tendency to give more value to evidence supporting those beliefs, even though they may not always be the most accurate. In finance, this leads investors to ignore very relevant information simply because it is distant from their usual point of view. Beliefs are not easy to uproot, so the only way to break out of this vicious circle is to change one's routine. It doesn't have to be a revolutionary movement; starting with small things is enough.
• Memory bias (the risk of only looking at the short term). The perfect example of how an investor should never reason is "The most recent events are the ones that will impact the portfolio the most; it's useless to think about the long term now." Focusing solely on the present leads to acting recklessly, greatly affecting risk perception.
• Loss aversion (does what you gain or what you lose count more?). Given the choice between receiving a €50 note or two, knowing that one of the two will be returned, most people will choose the first option, even though the end result is the same (here's an example explaining the bias related to fear of loss). It's all related to human psychology because emotions associated with loss have a very strong impact on the psyche. This leads investors to have a very high risk aversion, especially today, where we have continuous access to all information about our investments (the more often one looks at the performance of their portfolio, the more they will focus on risks). By reasoning in this way, the focus will only be on isolated events and immediate risks, while for being far-sighted investors, it's essential to have a broader and longer-term vision.
• Egocentric bias (learning from one's mistakes: what mistakes?). Savers/investors tend to talk about winning investments but never about the bad ones. This makes the consultant's job even more complicated. Very often, investors rely too much on their own perspective and/or have a higher opinion of themselves than reality. Talking about mistakes should not be seen as a punitive moment, but rather as a moment of growth (starting from where one went wrong to make more suitable decisions in the future).
• Intergroup bias (it's time to open the mind). "Every group thinks its customs are the only good ones, and if it observes that other groups have different customs, these provoke its contempt" (sociologist William Sumner, 1906). Individuals favor views closer to their group membership, belittling those perceived as different and external (this also happens in finance).

In conclusion, no one can avoid all behavioral biases, but if we are more aware of them, we can hope to have a more open mindset.