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Thursday, 1 November 2007

The Biases Investors Suffer From

I personally feel a host of people lose money in their investment not because of the capricious nature of the stock market but because of biases in the important investment decisions they make. Many investors unwittingly suffer from one form of bias or the other. In this discussion, I will draw the reader’s attention to the various forms of biases that investors suffer from. The biases investors primarily suffer from are: overconfidence, representativeness, conservatism, narrow framing and ambiguity aversion.

Self-attribution bias contributes to overconfidence bias. In self-attribution bias the investor is very quick to attribute the good results of investment decisions to himself and blame others or come up with excuses when things don’t work according to plan. This leads to overconfidence in one’s ability to select the right shares for a portfolio. It also leads to an irrational behaviour of not sufficiently diversifying one’s portfolio to reduce risk. Overconfidence bias supports the over-reaction hypothesis which states that markets rise too high when they rise and falls too low when they fall. When an overconfident person thinks the market will rise he invests enthusiastically, hence causing the market to rise more than necessary. On the other hand, a feeling that the market will fall leads to a progressively decreasing investment which causes the market to fall more than necessary. Overconfidence also explains why some investors trade more often, although they have to pay high charges every time they buy or sell shares.

Representativeness is to do with one projecting past successes or failures as also happening in the future. Thus some investors will invest a lot in a particular share just because it performed well in the past, or invest less in a security because it underperformed in the past. This sort of action or decision takes place in spite of concrete evidence that future performances cannot be guaranteed by past performances on the stock market. It is a form of bias.

Conservatism refers to a slow response to information or events. Research shows that a lot of investors only buy shares when it is about to peak in price and sells when it is just about to trough.

Narrow framing has to do with considering things from a smaller perspective than it should be. Looking at a long-term investment from a short-term perspective, is a good example. Some investors anxiously monitor daily changes in the prices of securities in a portfolio targeted at achieving an objective in 40 years’ time. Others as a result of this bias consider the volatility of the constituent securities of their portfolios, instead of looking at the risk of the portfolio as a whole. This can result in a rather meager investment, since individual securities in a portfolio tend to be more volatile than the portfolio itself.

Bias of ambiguity concerns investors’ preparedness to invest only in companies they know more about. A lot of investors prefer investing in companies in their own countries, even if investment in other countries can provide higher returns and also help to reduce risk.

One bias that is very closely related to narrow framing is that of retreivability, in which investors pay more attention to information that they can readily recall. Some investors will only support statements that coincide with their views, rejecting those that oppose the notion they hold. Others suffer from illusion of control. Some investors feel they are really in control of the investment situation, when in actual fact they are not. This type of bias explains why many investors pursue actively managed funds, irrespective of research findings that tracker funds outperform actively managed ones in the long-term.

Great dividends can be expected if the investor will use the above-mentioned biases as a checklist when making important investment decisions. Biases can warp the decision making mind of an investor, and foster irrationality and lack of objectivity. Taking appropriate measures to eschew biases is the first step towards investment success.

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