Biases in everyday life, and especially with regard to investment

A colleague recently brought up the topic of biases, and the influences of biases on investor behaviour, during a catch-up phone call. Working from home has in many respects led to less interaction and idea sharing than in bygone times when strolling over to the other’s desk was an option. My colleague deals with retail investors on a much more regular basis than I do and as such comes across these biases with respect to investor behaviour more frequently. In fact, mitigating the effects of biases in investment behaviours and educating the investor about biases may be one of the biggest value contributions that a good financial advisor brings to the table. Our conversation got me thinking of the potential impact of biases in a world where interaction with real people is limited and exposure to media and other digital influences may result in more of the negative behaviours often associated with biases.

Biases are inherent to being human. We all have them in some shape or form and they manifest themselves in our thinking processes on all topics of life. Investing happens to be one area of decision making that uncovers a disproportionate number of biases. Partly this has to do with the fact that investment plays such a big role in our future wellbeing. Investing is a process whereby, through facilitating the allocation of capital towards productive efforts, an amount of future certainty is sought through the growth of this capital. The more one has invested and the more successful that investment, the greater the future certainty generated.

This is simply because more money allows one to acquire better services and goods at critical times in the future when these may be needed, such as in poor health or retirement. It thus follows that investing for the future is a very rational pursuit which has important implications for future quality of life. However, the decision making process involves trade-offs between current and future spending as well as navigating the vast landscape of investment solutions available – which is often an emotional and overwhelming process to which our minds apply mechanisms for dealing with this complexity. These mechanisms are our biases.

Biases interfere with, and can even derail, the investment process and lead to suboptimal results when they do. As mentioned before, we all have biases. But not all of us have the same biases. Some of us suffer more from emotional biases while others fall victim to cognitive biases, and most of us exhibit a mixture of the two. Emotional biases are those that stem from feelings or an emotional predisposition and include overconfidence, self-control, and loss aversion. Emotional biases are often easier to detect through a process of introspection, but despite this are more difficult to address. If you have ever bought something on impulse that you know isn’t good for you or that you know will only provide fleeting satisfaction, then you understand the idea of emotional biases. These actions manifest themselves as a lack of self-control when purchasing that chocolate bar, or overconfidence that one will figure out a way to pay for that vehicle instalment when it becomes due, or indeed placing money in the bank instead of risking it in the stock market.

Cognitive biases, while easier to correct, are more difficult to detect. Cognitive biases are errors in thinking or reasoning and can be corrected through education or what the CFA Institute calls moderating. Cognitive biases include conservatism, confirmation, illusion of control, hindsight, anchoring, framing, mental accounting and many more. The terminology does not provide much insight into how these biases manifest themselves in our decision making processes but the broad groups into which they can be grouped do. Belief perseverancebiases, such as conservatism and confirmation, reflect our inclination to maintain our pre-existing beliefs. These are the biases which make it difficult to change our minds when presented with new and contradictory information about a political candidate, for example, or seeking out information that confirms our view of the world. The second broad group of cognitive biases are information processing biases such as anchoring, mental accounting and framing. These result in a skewed or vague view of information presented to us which in turn also leads to suboptimal decision making, especially with regard to investment.

It is during uncertain times like these that biases become more prevalent, if anything.

This leads us back to the question of addressing biases in the disruptive environment in which we currently find ourselves in. It is during uncertain times like these that biases become more prevalent, if anything. Access to a financial advisor may seem restricted and time seems to be more fleeting for most of us dealing with added distractions while working from home. It is easy to lose focus even for those sophisticated investors who are well versed in the art of managing their own portfolios, let alone those of us who have other professions that we dedicate our precious time to.

It is thus in times such as these that having a dedicated team allocating one’s capital according to a thoroughly drafted Investment Policy Statement (IPS) becomes so valuable. It is through the process of drafting an IPS that biases are detected and accountedfor in the investment process, mitigating the negative effects these may have on our desired outcomes. Such a dedicated and process-driven team will also ensure that one is kept up-to-date in a timely manner, even when keeping in touch is more challenging.

Eric van Zyl

Eric van Zyl is the head of research at IJG, an established Namibian financial services market leader. IJG believes in tailoring their services to a client’s personal and business needs. For more information, visit www.ijg.net.

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