Investment biases

The Sterling Report

TONI-ANN NEITA-ELLIOT

Sunday, October 13, 2019

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I have always been fascinated by how people think and why they do the things that they do, which is why I did a double major in management studies and psychology at university.

Many people found that to be a weird combination and I may, in fact, have been the only student doing that mix, as evidenced by how often many of my classes for the two different fields clashed! But I have never regretted it as my psychology education has served me well in my 18-year career in banking, finance and relationship management.

In fact, there is a relatively new field of study that combines psychological theory with conventional economics, called behavioural finance. Behavioural finance attempts to predict investment behaviour and is used as a basis for creating more efficient trading strategies.

One thing they have found that affects peoples' investment behaviour and decision-making process is biases. Whether we want to admit it or not, biases affect us all as investors and can cause us to make investment decisions based on feeling rather than fact.

There are many investment biases but here are a few that I encounter quite frequently.

CONFIRMATION BIAS

The reason that first impressions can be hard to shake is because we tend to selectively filter information. How often have you been convinced that the medical symptoms you are having are an indication of a particular illness, and you do a Google search and go “Ah ha!” once you have found an article that confirms your self-diagnosis and you don't search any further?

I admit I am guilty of that.

Similarly, an investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it. That is because we pay more attention to information that supports our opinions while ignoring the rest.

A good example of this is when we only recall all the great stories we have heard about the unbeatable returns that you can get by investing in real estate and ignore (or conveniently forget) the information that contradicts our belief that real estate is a slam dunk investment.

FAMILIARITY BIAS

Familiarity bias occurs when investors have a preference for familiar or well known investments, or ones issued or being distributed by a well known company. The investor may ignore bonds or stocks issued by international companies and instead opt for securities offered by local companies, without any research, simply because they are more familiar with them; when in fact the international company may be larger and more financially sound!

I have seen many investors fall victim to this bias. For example, about two years ago a prospective client asked me about a bond issued by a well known company that operates in Jamaica and worldwide. I told them that we were not recommending it based on analysis of the company's financials. However, the person dismissed my warning and said, “But everyone knows that company. They have so many customers, so they must be doing well!”

I really hope that prospective customer did not end up buying the bond, as it subsequently became distressed, necessitating a restructuring of its terms to less-favourable ones.

TREND-CHASING BIAS

Many investors or traders will select investments because of a current strong performance, based on the mistaken belief that historical returns predict future performance.

The feeling that “I'm missing out on great returns” or “Everyone is investing in it” has probably led to more bad investment decisions than any other single factor. Warren Buffett said it best. As an investor it is wise to be “Fearful when others are greedy and greedy when others are fearful.”

I am sure if you think about it, you can think of times where you witnessed all three of these biases in action at the same time or have fallen victim yourself.

If you are investing in an IPO, for example, simply because;

(1) the company is familiar or it is being arranged by a familiar broker “So it must be a good investment”,

(2) because everyone seems to be investing in IPO's; and

(3) your friend told you that they doubled their money on the last IPO they went into, ignoring the fact that another one of your friends has lost money in an IPO,

then you are making a decision based on familiarity bias, trend-chasing bias, and confirmation bias — all at the same time!

Giving in to your biases can lead to suboptimal portfolios with a greater a risk of losses.

Working with a financial planner can help investors recognise and understand their own individual behavioural biases and predispositions, in order to avoid making investment decisions based entirely on those biases.

Toni-Ann Neita-Elliott is the AVP, personal financial planning at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm


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