Behavioral Biases

Behavioral Biases

Loss aversion refers to the irrational dislike of losses in a portfolio. It manifests when an investor, despite recognizing a stock’s positive metrics and including it in their portfolio, impulsively sells it when it faces a downturn. Goals-based investing offers a solution to this bias by ensuring that the investor’s priorities remain the focus, thus discouraging them from deviating from their strategic asset allocation during market downturns. By clearly focusing on their goals, investors can mitigate the impact of loss aversion and make more rational investment decisions.

Illusion of control refers to the erroneous belief that positive investment performance is primarily attributed to investors’ ability to influence events beyond what is realistically possible. This bias is often observed among risk-seeking investor types, particularly active accumulators. The illusion of control manifests in excessive trading and a failure to diversify the portfolio adequately. Investors under this bias overestimate their control over investment outcomes, leading to suboptimal decisions and increased risk exposure.

Mental accounting refers to the tendency of investors to categorize their wealth into arbitrary compartments mentally. An example of mental accounting is when investors hold onto low-yielding government bonds received as a birthday gift while using high-interest credit cards. This bias can lead to suboptimal financial decisions since it overlooks the financial picture and focuses on individual categories in isolation. However, goals-based investing is designed to effectively address this bias by emphasizing the investor’s broader financial goals and priorities, encouraging a more holistic and rational approach to wealth management.

Representativeness bias, also called recency bias, influences investors to assign greater significance to information based on its recency. This bias can lead investors to overemphasize recent events, such as an economic crisis, and make decisions based solely on these recent experiences. For instance, an investor may continue to invest cautiously and adopt a defensive approach to their financial decisions even though the business cycle is expected to evolve and change over time. To mitigate this bias, employing techniques rooted in modern portfolio theory and mean-variance optimization (MVO) can be beneficial. These approaches help investors take a more comprehensive and forward-looking view of their portfolios, considering long-term trends and diversification strategies rather than being solely driven by recent events.

Framing bias pertains to the tendency of investors to evaluate information based on how it is presented rather than its objective content. This bias can lead to different perceptions and decisions based on the framing of the information. For instance, consider the classic question of whether the glass is half-full or half-empty. An investor influenced by framing bias may be more inclined to focus on a situation’s negative aspect (half-empty) or the positive aspect (half-full), depending on how it is presented.

An example of framing bias impacting asset allocations is when an investor approves a portfolio with a 95% success rate but disapproves of a 5% failure rate. As a result, the investor may opt for an overly conservative portfolio to minimize the perceived risk of failure. To mitigate the impact of framing bias, investment professionals should strive to present a comprehensive range of information to clients. This entails providing a balanced view of the potential risks and rewards associated with different investment options, ensuring that clients have a more complete understanding of the implications of their decisions. Investment professionals can help clients make more informed and objective asset allocation choices by presenting information neutrally and transparently.

Availability bias refers to the tendency of individuals to rely on information that is easily accessible or readily available. According to this theory, widely disseminated information is often given more credibility than information that requires effort. Ideally, the importance and credibility of information should not be solely determined by its availability. Instead, it should be evaluated based on its value and usefulness in making informed decisions.

In investing, availability bias can manifest when investors hear of a hot stock tip at a social gathering and feel compelled to incorporate it into their portfolio. This information is readily available, possibly without the need for the listener to actively search for it. However, the true worth of the tip should be assessed based on objective performance metrics such as the Sharpe Ratio and its alignment with the investor’s goals and constraints. These measures provide a more sophisticated and comprehensive evaluation of information.

One practical approach to mitigating availability bias is starting with a globally diversified market portfolio and then making adjustments as necessary. By basing investment decisions on the broad market portfolio rather than solely on readily accessible information, investors can reduce the impact of availability bias. This approach ensures a more balanced and objective assessment of investment opportunities. It insists on considering the potential contribution of investments to portfolio performance and their suitability within the investor’s overall financial objectives and constraints.

Investment Governance

To address the various behavioral biases that can lead to potential pitfalls in investment decision-making, incorporating a robust corporate governance framework is a highly effective response. Strong corporate governance is crucial in establishing clear and well-defined goals and constraints for the portfolio, supported by proper documentation. It provides a solid foundation by implementing frameworks and necessary processes for investment activities and ongoing performance monitoring, complemented by periodic audits.

By integrating strong corporate governance practices, decision risk can be mitigated. Decision risk refers to the risk of abandoning a strategic investment approach at the worst possible time, often driven by behavioral biases. A sound corporate governance framework ensures investment decisions are guided by established strategies and objectives, preventing hasty and impulsive changes based on short-term market fluctuations or emotional biases.

Furthermore, by promoting transparency, accountability, and effective oversight, corporate governance enhances investment processes’ overall integrity and reliability. It helps to ensure that investments align with the predefined goals and constraints, allowing for a systematic and disciplined approach to portfolio management. Corporate solid governance safeguards against behavioral biases and promotes long-term success in investment endeavors by fostering a culture of responsible decision-making and adherence to established guidelines. 

Question

An investor’s enthusiastic involvement in the options market leads to frequent and rapid trading activity within their portfolio. They engage in multiple buy and sell transactions within a single day. However, upon meeting a CFA (Chartered Financial Analyst), the investor discovers that their geometric average return has been negative despite a modest overall market increase. Which behavioral bias is most likely responsible for this erratic behavior?

1. Mental Accounting.
2. Loss Aversion.
3. Illusion of Control.

Solution

The correct answer is C.

The illusion of control bias most likely drives the investor’s erratic trading behavior. This bias suggests that the investor believes they possess superior abilities or control over their portfolio outcomes beyond what is realistically possible. As a result, they engage in frequent trading, aiming to exert influence and generate positive returns. However, their actual performance, indicated by a negative geometric average return despite a modest market increase, highlights the unrealistic nature of this belief in controlling investment outcomes.

A is incorrect: The investor’s behavior in this question does not align with the concept of mental accounting, which involves segregating wealth into arbitrary categories. In this case, the investor’s issue lies in frequent trading and negative geometric average return, indicating a different underlying behavioral bias.

B is incorrect: Loss aversion, an irrational dislike of losses, is not the underlying bias in this case. The investor’s behavior cannot be solely attributed to a misunderstanding of the portfolio’s magnitude of losses and gains. Other factors drive the investor’s erratic behavior, indicating a different behavioral bias.

Reading 6: Asset Allocation with Real-World Constraints

Los 6 (e) Identify behavioral biases that arise in asset allocation and recommend methods to overcome them.