Friday, November 18, 2011

Be Aware Of These Biases

Daniel Nevins is a managing director at SEI Investments. Not unlike Charlie Munger (whose discussion of human tendencies we have summarized), Nevins is a student of human biases which cause individuals to underperform as investors. In his paper titled Integrating Traditional and Behavioral Finance, Nevins notes the following biases:

Investors overestimate their ability to predict market events. This leads to overtrading and taking on too much risk.

People become honestly deceived when an event occurs, thinking that they had predicted such event even when they had not. This trait reinforces overconfidence.

The human mind looks for patterns. But sometimes events occur which are random or cannot be predicted. Nevertheless, investors over-interpret patters that are coincidental, leading to illogical behaviour.

Belief Perseverance
People are unlikely to change their opinions once they have been formed, for two reasons. First, people are reluctant to search for evidence that contradicts what they believe to be true. Second, even when faced with such evidence, it is treated with skepticism or not given the weight it merits.

Regret Avoidance
This is a tendency to avoid or postpone actions that create discomfort. For example, investors hold on to losing stocks, as selling them would be a confirmation of a poor prior decision, and this confirmation does not sit well. (Note that Belief Perseverance can also play a role in this action.)

By understanding these biases, investors put themselves in a position to avoid falling prey to them. By recognizing that such tendencies may be playing a role in investment decisions, individuals can take steps to mitigate them or implement procedures for decision-making that are more objective.

For those interested in reading more on the subject, the full paper is available here.

1 comment:

Stable Investor said...

As humans, it is almost impossible to eliminate biases from our decision making process. At best we can make an effort to reduce the speculative component in our investment decisions