Investor Psychology: Overcoming The Bias of Human Psychology
In this series we drill into the biggest issues that investors face when it comes to psychology.
As humans we have deeply ingrained behavioural biases in our psyche. These biases are used in our day-to-day functioning and allow us to navigate social and physical situations intuitively.
However, in the world of investing, where structure, repetitiveness and singular resolve are needed, overcoming these ingrained biases is paramount.
Investor behavioural biases comprise both cognitive and emotional biases. Cognitive biases derive from information processing, statistical or memory errors. Emotional biases derive from impulse or intuition which can lead to behavioural action based on feelings rather than facts.
There are numerous manifestations of investor biases, the five we will concentrate on in this series are:
- Self-attribution - overconfidence
- Loss aversion
- Heuristic simplification (misuse of information)
- Social influence (culture)
- Familiarity bias in diversification
Chapter 1: Self-attribution – overconfidence
Humans are generally an optimistic group that tend to view the world positively. This optimism can lead to a ‘self-deception’ of our abilities. Multiple studies of certain groups of people, for example, doctors, lawyers and CEOs, have found these individuals have unrealistically positive self-evaluations and overestimations of ability. While confidence is a valuable trait, in investment decision-making it can lead to overconfidence.
Overconfidence falls under the emotional bias in psychology. When applied to investing, that overconfidence leads investors to believe they have more control over their investments than they truly do. Investing involves forecasting and in-depth analysis of the future; overconfident investors can overestimate their abilities to identify successful investments which can lead to mistakes and loss. What’s even more interesting about overconfidence bias is that experts frequently overestimate their own abilities more than a typical person.
A study in the late 90’s found that wealthy investors believed that it was their own stock-picking skills that was critical to their portfolio performance. In reality, they had overlooked broader influences on performance and their portfolios had actually just kept pace with the market itself.
The most extreme examples of an overconfident investor occur when they have become involved in investment fraud. Economist Steven Pressman identified overconfidence as the underlying behaviour responsible for the susceptibility to financial fraud.
Self-attribution bias is defined as attributing successes to one’s personal skills, and failures to factors beyond their control. In investing, self-attribution occurs when investors attribute investment success to their own actions and adverse investment outcomes to external factors. Psychology sees self-attribution bias as a means of self-protection or self-enhancement – in the world of investing it is very understandable why investors experience and exhibit this bias.
Self-attribution bias in investors can lead to overconfidence or for the investor to dismiss investment mistakes, which can lead to underperformance. One technique to mitigate self-attribution bias is for investors to track personal investment mistakes and successes and develop accountability mechanisms.