Are you biased?

Posted by dfederman on Aug 31, 2011 in Market News | Comments Off

Experts in the fields of behavioral finance and neuroeconomics have found that humans are susceptible to developing biases. A bias is a preconceived notion, preference, or tendency that, once adopted, is difficult to alter or overcome.

Here are some of the common biases we often see:

Mental anchoring is an attachment to past events, situations, numbers, ideas, explanations, or impressions, that tend to block thinking. The mind ignores other aspects of the situation, and particularly neglects new events (or a sounder analysis of the available information) that make the situation different from the past (or from the way we evaluated it in the past). This often leads to biased decisions. The investor’s mind often stays focused or  stuck on a past price reference (his/her buying price for example, or sometimes a round price, or a past peak price, or some rigid / stubborn objective decided in the past…). He / she does not accept to sell an asset he / she owns if its current price is under that reference price, even if its future price prospect has been dwindling. Therefore he/she takes the risk of losing more money by keeping an asset that did not keep its promises.

Confirmation bias is a tendency for investors to look for and admit as relevant only information that confirm their prior beliefs, and/or to interpret whatever information in a sense that fits those preconceptions.

Recency bias is to give more importance to recent events than to older ones. It is a kind of mental myopia that focuses on the most recent information. A common example in asset markets is the expectation that some assets which have been fashionable until now will keep being popular in the near future.

Catastrophisizing Bias – Similar to Recency Bias. Extrapolating today’s bad news indefinitely into the future. “Things are terrible today, and will always be terrible. The stock market will NEVER recover.” “Gold is going to keep going up and up and up.”

Mental accounting/compartmentalizing bias – using separate criteria to value and to deal with your different economic assets, transactions, situations or expectations. The “house money” effect is a good example. People are usually rather cautious on the risk/return prospects when they invest their hard earned savings. But when they sell their winners for profits they view their profits as “house money” with which they can speculate.