Byron S. Sass, BridgeTower Media Newswires
Modern portfolio theory has been at the core of many investors’ decision-making process, with the focus being on the efficient market hypothesis. The theory is based on three basic assumptions: (1) the markets are efficient, (2) investors all have the same access to information, and (3) investors are rational in their investment decisions. The last assumption, that investors are rational, has been challenged by another field of study referred to as behavioral finance. Behavioral finance examines how investors’ behavior impacts markets on a micro and macro level. One thing that has arisen is the fact that not all investors act in a rational manner when making investment decisions. When they deviate from rational behavior it is often a result of a bias to which the investor is not often aware.
Biases affect individuals in all aspects of life. As a simple example, they result in paying more for a name brand instead of generic brand despite being exactly the same except for the product’s manufacturer. Biases can and do impact and influence investors as well as their decisions. More often than not these biases can have an adverse impact on the investor’s portfolio and undermine otherwise sound investment strategies.
Biases in investing can be separated into two main camps, one being cognitive biases and the other emotional biases. A cognitive bias can be described as an error in processing information or data that results in an investor making an irrational investment decision in the view of traditional finance. Alternatively, an emotional bias can be described as when emotions or an attitude arise and result in an irrational investment decision in the view of traditional finance.
One type of a cognitive bias is confirmation bias, in which an individual only seeks out information that confirms or reaffirms their investment belief while excluding any information that is contrary to their investment thesis. An example would be an investor who invests in company XYZ with a favorable outlook on the stock price. After a while the investor reassesses the investment prospects. An investor with a confirmation bias would only focus on the growing total sales number for an investment in company XYZ but would simultaneously ignore the fact the earnings have been negative because of an unforeseen cost, which then eats into the company’s profits. In this case, the investor is only seeking out positive information that confirms their investment outlook and disregarding information that is contrary to their belief.
One type of an emotional bias is loss aversion bias. This occurs when an investor holds on to a losing investment to avoid realizing losses while also hoping that it will turn around. An example of an emotional bias would be where an investor buys investment ABC and within a month the investment loses value because of unanticipated negative news. An investor with loss aversion bias would either hold the position or double down and purchase more shares, instead of recognizing that the investment did not work out and they should be cutting their losses.
There are countless biases, both cognitive and emotional in nature, that can affect investors’ choices. To help minimize the impacts of their biases, investors can review past investment decisions and work with an investment professional to help them recognize and focus on understanding the potential biases they may be susceptible to. Like any decision making process though, successful investors understand that being retrospective and understanding their tendencies can help them make better independent assessments of choices before them.
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Byron S. Sass is a Fixed Income Analyst for Karpus Investment Management, an independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534 (585-586-4680).
