How Biases Affect Investor Behaviour

This is a copy of paper published by H. Kent Baker and Victor Ricciardi. The paper talks about how biases affect investor behaviour in taking investment decision. Investor behaviour often deviates from logic and reason, and investors display many behaviour biases that influence their investment decision-making processes. H. Kent Baker and Victor Ricciardi describe some common behavioural biases and suggest how to mitigate them. Baker and Ricciardi, in this paper mainly talks about 8 biases. The paper can be downloaded here

1. Representativeness. Representativeness results in investors labelling an investment as good or bad based on its recent performance. Consequently, they buy stocks after prices have risen expecting those increases to continue.

2. Regret (loss) aversion. Regret aversion describes the emotion of regret experienced after making a choice that turns out to be either a bad or inferior choice.

3. Disposition effect. Closely related to regret aversion is the disposition effect, which refers to the tendency of selling stocks that have appreciated in price since purchase (“winners”) too early and holding on to losing stocks (“losers”) too long.

4. Familiarity bias. This bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification.

5. Worry. The act of worrying is an ordinary and unquestionably wide spread human experience. Worry educes memories and visions of future episodes that alter an investor’s judgement about personal finances.

6. Anchoring. Anchoring is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgements. Anchoring occurs when an individual lets a specific piece of information control his cognitive decision-making process.

7. Self-attribution bias. Investors who suffer from self-attribution bias tend to attribute successful outcomes to their own actions and bad outcomes to external factors. They often exhibit this bias as a means of self-protection or self-enhancement.

8. Trend-chasing bias. Investors often chase past performance in the  mistaken belief that historical returns predict future investment performance. Mutual funds take advantage of investors by increasing advertising when past performance is high to attract new investors.

These eight behavioural biases are some fundamental issues investors might face at different periods during their lifetimes. Another important issue to consider is the amount of attention and time they should spend on their investment decisions.

One of the possible way to overcome these biases, is to buy and hold whole market via index funds or ETFs.