Investments and Human Biases
In yesterday’s post, I was saying that emotions are one of the five pillars that affect our investment decisions. I am coming today with more information on that topic, particularly focusing on human biases. Short disclaimer: some of the ideas presented here are taken from “Thinking, Fast and Slow” by Daniel Kahneman.
Humans are highly affected by emotions and susceptible to different types of biases, such as loss aversion bias, herding bias, confirmation bias, or overconfidence bias. Let’s discuss each of those and see how it affects us.
1 Loss aversion bias: we are naturally inclined to be more affected by losses than gains, even though the outcome is the same, and it is just a matter of different framings. Here is an example:
If you stop smoking, you will live 5 years longer.
If you continue smoking, you will die 5 years earlier.
Though technically the same outcome is described in both situations, the majority of people will be more inclined to quit smoking when hearing option no. 2. The same applies to investments.
2 Herding bias: we are naturally more inclined to buy or sell when other people are doing the same, even though it is counter-productive to good investment behaviour.
Whenever I am on the edge of displaying herding bias, I like remembering myself the following saying credited to Baron Rothschild, an 18th-century British nobleman and member of the Rothschild banking family: "the time to buy is when there's blood in the streets."
3 Confirmation bias: we naturally seek approval from other people, we are looking for people who confirm our beliefs, ignoring information that contradicts our views. This might result in disastrous outcomes for investment decisions, as most of the time we choose news and information that confirms our opinions, instead of searching for disconfirming evidence to have the overall picture.
4 Overconfidence bias: we tend to have a misleading assessment of our skills, intellect, talent, or the ability to predict the future
In order to combat this one, we should keep in mind that it is statistically impossible for most investors to perform better than the average.