What Is Bias?
Bias is an illogical or irrational preference or prejudice held by an individual, which may also be subconscious. It's a uniquely human foible, and since investors are human, they can be affected by it as well. Psychologists have identified more than a dozen kinds of biases, and any or all of them can cloud the judgment of an investor.
Key Takeaways
- Bias is an irrational assumption or belief that affects the ability to make a decision based on facts and evidence.
- Investors are as vulnerable as anyone to making decisions clouded by prejudices or biases.
- Smart investors avoid two big types of bias—emotional bias and cognitive bias.
Understanding Bias
Besides warping the ability to make a decision based on facts and evidence, bias also tends to ignore evidence that doesn't align with that assumption.
A bias can be a conscious or unconscious mindset. When investors take biased action, they fail to acknowledge evidence that contradicts their assumptions.
Smart investors avoid two major types of bias: emotional and cognitive. Controlling them can allow the investor to reach a decision based on available data.
Relying on bias rather than hard data can be costly.
Common Biases in Investing
Psychologists have identified a number of types of bias that are relevant to investors:
- Representative bias may lead to snap judgments because of a situation's similarities to an earlier matter.
- Cognitive dissonance leads to an avoidance of uncomfortable facts that contradict one's convictions.
- Illusion of control bias is a cognitive belief where investors overestimate their ability to influence outcomes.
- Home country bias and familiarity bias lead to an avoidance of anything outside one's comfort zone.
- Confirmation bias describes how people naturally favor information that confirms their previously existing beliefs.
- Mood bias, optimism (or pessimism) bias, and overconfidence bias all add a note of irrationality and emotion to the decision-making process.
- The endowment effect causes people to overvalue the things they own just because they own them.
- Status quo bias is resistance to change.
- Outcome bias assumes a future result will happen based on previous events without regarding how those past events developed.
- Reference point bias and anchoring bias are tendencies to value a thing in comparison to another thing rather than independently.
- The law of small numbers is the reliance on a too-small sample size to make a decision.
- Mental accounting is an irrational attitude towards spending and valuing money.
- The disposition effect is the tendency to sell investments that are doing well and hang onto losers.
- Attachment bias is a blurring of judgment when one's own interests or a related person's interests are involved.
- Changing risk preference is the gambler's fatal flaw: a small risk, no matter what the outcome, creates a willingness to take on greater and greater risks.
- Media bias and Internet information bias represent uncritical acceptance of widely reported opinions and assumptions.
Example of Bias
Bias can be seen in the way people invest. For example, endowment bias can lead investors to overestimate the value of an investment simply because they bought it. If the investment loses money, they insist they're right andthe market will surely correct its error. They may reinforce this belief by reviewing all the reasons it was worth what they paid, ignoring why its value fell. An investor with implicit bias might bypass an otherwise profitable investment based on negative biases about where the company is located or its stance on public issues.
The rational investor will review all of the positive and negative data and decide whether objectively about their investments.
