Investors’ 10 Most Common Behavioral Biases

Cognitive HazardBarry Ritholz (of The Big Picture and a Sunday Business columnist at The Washington Post) recently contributed Investors’ 10 most common mistakes to The Washington Post Business Section quarterly investing section. It’s a commentary that he has been working on for a while — the ten topics are listed with links to longer discussions of each common mistake here. I created my own investing “checklist” (here) in response to Barry’s original list. For yet one more iteration of the theme, I offer my list of Investors’ 10 Most Common Behavioral Biases.  There are a number of others, of course, and more will continue to be uncovered.  But I think that these are the key ones.  Your suggestions of important ones I have missed are welcome.

  1. Confirmation Bias. We like to think that we carefully gather and evaluate facts and data before coming to a conclusion.  But we don’t. Instead, we tend to suffer from confirmation bias and thus reach a conclusion first.  Only thereafter do we gather facts and see those facts in such a way as to support our pre-conceived conclusions.  When a conclusion fits with our desired narrative, so much the better, because narratives are crucial to how we make sense of reality.
  2. Optimism Bias.  This is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy. Indeed, we live in an overconfident, Lake Wobegon world (“where all the women are strong, all the men are good-looking, and all the children are above average”).  We are only correct about 80% of the time when we are “99% sure.” Fully 94% of college professors believe they have above-average teaching skills (anyone who has gone to college will no doubt disagree with that). Since 80% of drivers  say that their driving skills are above average, I guess none of them drive on the freeway when I do.  While 70% of high school students claim to have above-average leadership skills, only 2% say they are below average, no doubt taught by above average math teachers. In a truly terrifying survey result, 92% students said they were of good character and 79% said that their character was better than most people even though 27% of those same students admitted stealing from a store within the prior year and 60% said they had cheated on an exam. Venture capitalists are wildly overconfident in their estimations of how likely their potential ventures are either to succeed or fail. In a finding that pretty well sums things up, 85-90% of people think that the future will be more pleasant and less painful for them than for the average person.
  3. Loss Aversion. We are highly loss averse.  Empirical estimates find that losses are felt between two and two-and-a-half as strongly as gains.  Thus the disutility of losing $100 is at least twice the utility of gaining $100. Loss aversion favors inaction over action and the status quo over any alternatives. Therefore, when it comes time for us to act upon the facts and data we have gathered and the analysis we have undertaken about them, biases 2 and 3 – unjustified optimism and unreasonable risk aversion – conflict. As a consequence, we tend to make bold forecasts but timid choices. 
  4. Self-Serving Bias. Our self-serving bias is related to confirmation bias and optimism bias. Self-serving bias pushes us to see the world such that the good stuff that happens is my doing (“we had a great week of practice, worked hard and executed on Sunday”) while the bad stuff is always someone else’s fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).
  5. The Planning Fallacy.  In his terrific book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” It’s a corollary to optimism bias and self-serving bias. Most of us overrate our own capacities and exaggerate our abilities to shape the future.  The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.  It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect.  It’s why the results we achieve aren’t as good as we expect. 
  6. Choice Paralysis. Intuitively, the more choices we have the better.  However, the sad truth is that too many choices can lead to decision paralysis due to information overload.  For example, participation in 401(k) plans among employees decreases as the number of investable funds offered increases. We are readily paralyzed by too many choices.
  7. Herding. We all run in herds — large or small, bullish or bearish.  Institutions herd even more than individuals in that investments chosen by one institution predict the investment choices of other institutions by a remarkable degree.  Even hedge funds seem to buy and sell the same stocks, at the same time, and track each other’s investment strategies. That affinity fraud  (e.g., Bernie Madoff fleeced the Jewish community to which he belonged) is so common is definitive evidence of herding.
  8. We Prefer Stories to Analysis.  As noted above, narratives are crucial to how we make sense of reality.  They help us to explain, understand and interpret the world around us.  They also give us a frame of reference we can use to remember the concepts we take them to represent.  Perhaps most significantly, we inherently prefer narrative to data — often to the detriment of our understanding.  Keeping one’s analysis and interpretation of the data reasonably objective – since analysis and interpretation are required for data to be actionable – is really, really hard even in the best of circumstances. A corollary to this problem and to confirmation bias is what Nassim Taleb calls the “narrative fallacy” — looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen.
  9. Recency Bias. We are all prone to recency bias, meaning that we tend to extrapolate recent events into the future indefinitely. As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weightings of stocks, bonds and cash.  The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommended weighting came just after the lows of the financial crisis. That’s recency bias.
  10. The Bias Blind-Spot. I have written many times about the cognitive biases which plague us and make it difficult for us to make good choices, including (obviously) here.  Knowing about them is imperative if we are going to deal with them.  We would always be wise to factor in these biases when performing analysis and making decisions. Unfortunately, we all tend to share a “bias blind spot” — the inability to recognize that we suffer from the same cognitive distortions that plague other people. Here is a wonderful (both hysterically funny and achingly sad) example.
About these ads

116 thoughts on “Investors’ 10 Most Common Behavioral Biases

  1. Pingback: Gute Artikel, Research usw. - Seite 4

  2. Pingback: Stuff I’m reading: Investors’ 10 Most Common Behavioral Biases » st0ckthief

  3. Pingback: 10 Tuesday AM Reads | The Big Picture

  4. Pingback: Tuesday links: the goal of trading | Abnormal Returns

  5. Pingback: Linkfest:July 18, 2012 | Alpha Ideas

  6. Pingback: Recomendaciones « intelib

  7. Pingback: Weekend Links July 20 2012

  8. Wow. Was that maybe one of the most insightful but concise blog posts I have seen in years? I think it might be. Good job.

  9. Pingback: The Long Cycle | Above the Market

  10. Pingback: Happy Blogiversary to Me | Above the Market

  11. Pingback: Linkkilista (vko32) « Mietteitä Sijoittamisesta

  12. Pingback: Investors’ 10 Most Common Behavioral Biases | learningvalueinvesting

  13. Pingback: Reckoning with Risk (2) | Above the Market

  14. Pingback: Weekend links while I’m at FINCON | Military Retirement & Financial Independence

  15. Pingback: Confirmation Bias Illustrated | Above the Market

  16. Pingback: Risk Management - Required Reading for Stock Market Investors

  17. Pingback: Complexity Risk Management — a lot like Jazz | Above the Market

  18. Pingback: The Greatest Risk of All | Above the Market

  19. Pingback: Old Always | Above the Market

  20. Pingback: Bias Blindness and Polarization | Above the Market

  21. Pingback: Hope and Change | Above the Market

  22. Pingback: The Financial Forest | Above the Market

  23. Pingback: Investors’ 10 Most Common Behavioral Biases | Above the Market

  24. Pingback: Deep Bias | Above the Market

  25. Pingback: 10 Weekend Reads | The Big Picture

  26. Pingback: Vote (and some related implications) | Above the Market

  27. Pingback: Rock You Like a Superstorm | Above the Market

  28. Pingback: Data Beats Your Lyin’ Eyes | Above the Market

  29. Pingback: Carolina Crazy | Above the Market

  30. Pingback: 10 Tuesday PM Reads | The Big Picture

  31. Pingback: The NFL, Data and Player Safety | Above the Market

  32. Pingback: My Top Posts for 2012 | Above the Market

  33. Pingback: Top Ten Ways to Deal with Behavioral Biases | Above the Market

    • Thanks for reading and commenting. Wiki is a decent place to start, but if you follow the links in my posts on the subject you can see some of the actual published research on bias blindness. See here, for example.

  34. Pingback: Top Ten Ways to Deal with Behavioral Biases « Portfolio Investing Blog: Portfolioist

  35. Pingback: Somewhere else, part 3 | Freakonometrics

  36. Pingback: 7 Super Bowl Investing Lessons | Above the Market

  37. Pingback: Establishing Your Top 10 Investment Default Settings | Above the Market

  38. Pingback: Confirmation Bias Writ Large | Above the Market

  39. Pingback: We Suck at Probabilities | Above the Market

  40. Pingback: Best links of the web: 12-07-18, nr 590 | Lukas Daalder

  41. Pingback: Edge: Milevsky, Ritholtz, Zweig, Ferri and More | Above the Market

  42. Pingback: The Price of Safety | Above the Market

  43. Pingback: Retirement shortfall: Misplaced expectations | Above the Market

  44. Pingback: Behavioral Biases in Investing | EarlyRetireDoc

  45. Pingback: The Missing Lead | Above the Market

  46. Pingback: ‘Burying the lead’ on investor mistakes | Find Missoula Homes

  47. Wow that is a great list of biases that we can have. As a Financial Planner not only have I experienced these in my professional life many of them came up in my personal life too. In the last 7 years I have been researching the effect of money scripts on our behavior and our relationship with money. Many of us have not had any formal education on money before we entered the work force. From my research I have learned that 95% of our subconscious programming was done by the age of 12. If we don’t realize that we live only 5 to 1% of our life in conscious realm we are setting ourselves to fail in every are of life especially in finance. I believe many of the biases you have listed in your article come from our past programming. We must become aware of this fact before we can change anything.

  48. Pingback: “What are you sinking about?” | Above the Market

  49. Pingback: Sunday Sermon | Above the Market

  50. Pingback: What’s Next? | Above the Market

  51. Pingback: Choice | Above the Market

  52. Pingback: The Semmelweis Reflex | Above the Market

  53. Pingback: Motivated Reasoning | Above the Market

  54. Pingback: Connecting the Dots | Above the Market

  55. Pingback: Lessons from “Trader Vic” | Above the Market

  56. Pingback: “It Has a Place” | Above the Market

  57. Pingback: Signposts: A Daily (Baker’s) Dozen for Investors | Above the Market

  58. Pingback: Think Like a Scientist | Above the Market

  59. Pingback: What’s Your Baseline? | Above the Market

  60. Pingback: Investor Bias

  61. Pingback: Equal Time: Mean Reversion | Prudent Trader

  62. Pingback: Shifting Baseline Syndrome | Above the Market

  63. Pingback: The Tuned Market | Above the Market

  64. Pingback: Financial Advice: A Top Ten List | Above the Market

  65. Pingback: AAII Citations | Above the Market

  66. Pingback: Finance blogger wisdom: mandatory retirement savings | Abnormal Returns

  67. Thanks for the list, Bob. I can’t help but think of clients when reading bias #6. Advisors face a choice bias, but for clients it turns into a bias from information-overload. I see it often. Too much info crammed into a report actually reduces their understanding and ultimately hurts the advisor/client relationship. Fewer choices paired with more consolidated reporting = magic.

  68. Pingback: Investors, their mistakes, and overcoming them - Edge Portfolio Management

  69. Pingback: On Free Will | Above the Market

  70. Pingback: How did they do? | Above the Market

  71. Pingback: Happy Blogiversary to Me | Above the Market

  72. Pingback: MAGAZIN Cele mai bizare parcuri de distractii din lume. De ce traiesc femeile mai mult? Cele mai bune inventii ramase necunoscute. Cele 10 erori comune. TED Talks

  73. Pingback: MAGAZIN Cele mai bizare parcuri de distractii din lume. De ce traiesc femeile mai mult? Cele mai bune inventii ramase necunoscute. Cele 10 erori… - Gogoloi

  74. Pingback: The Tragedy of Errors | Above the Market

  75. Pingback: The Tragedy of Errors | Thought Equity

  76. Pingback: We Always Know Less Than We Think | Above the Market

  77. Pingback: Paradigm Shifting | Above the Market

  78. Pingback: “Assume a Spherical Cow” | Above the Market

  79. Pingback: Picasso, Skill and Luck | Above the Market

  80. Pingback: What Works | Above the Market

  81. Pingback: Data-Driven Difficulties | Above the Market

  82. Pingback: Behavioral biases, ways in which we messy humans hold ourselves back and some good potential solutions! | MoneyMusclesMind

  83. Pingback: Investment Learning from the Law | Above the Market

  84. Pingback: Enhancing Performance With Bias Awareness | SMB Capital - Day Trading Blog

  85. Pingback: How the Markets Work | Above the Market

  86. Pingback: Too Sure By Half | Above the Market

  87. Pingback: Hope for the Future | Above the Market

  88. Pingback: 2013′s Best (#8): The Tragedy of Errors | Above the Market

  89. Pingback: 2013′s Best (#6): We Suck at Probabilities | Above the Market

  90. Pingback: 2013′s Best (#4): Top Ten Ways to Deal with Behavioral Biases | Above the Market

  91. Pingback: 2013′s Best (#3): Financial Advice: A Top Ten List | Above the Market

  92. Pingback: 2013′s Best (#1): Establishing Your Top 10 Investment Default Settings | Above the Market

  93. Pingback: Investment decision making: diversity over biology | Abnormal Returns

  94. Pingback: What Do You Believe In? | Above the Market

  95. Pingback: What Do You Believe In? | Thought Equity

  96. Pingback: Get Real | Above the Market

  97. Pingback: We Are Less Than Rational | Above the Market

  98. Pingback: The Relentless (for now) Bid | Above the Market

  99. Pingback: Five Stinkin’ Feet | Above the Market

  100. Pingback: “In all probabilistic fields, like investing and gambling, the best performers dwell on process.” | Bamboo Innovator

  101. Pingback: We Was Robbed | Above the Market

  102. Pingback: There’s No Substitute for Good Judgment | Above the Market

  103. Pingback: Recency bias in fund flows | Abnormal Returns

  104. Pingback: Laugh or Cry? | Above the Market

  105. Pingback: Optimism Bias at Work | Above the Market

  106. Pingback: CFA Conference: C. Thomas Howard | Above the Market

  107. Pingback: The Backfire Effect | Above the Market

  108. Pingback: Trading Biases - I Think I Got Them All | Rightview Trading

  109. Pingback: Happy Blogiversary to Me! | Above the Market

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s