Thursday, 15 October 2015 - 20:00

 

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Seed Weekly - Biases

We are all biased.

No-one can claim that they are not biased to some degree. Even the paragon of today’s rational investor is biased. The best we can do is to acknowledge this and do our best to be aware of our biases when we make decisions.

Biases can be broadly broken into 2 categories, emotional and cognitive. Let’s start with the latter.

Cognitive Biases

Cognitive biases stem from errors in the way we process and remember the information we use to make decisions. If the information is not ‘stored’ or processed correctly we tend to make decisions that would not necessarily be regarded as rational or optimal. Cognitive biases can be further broken down onto several more specific sub categories. We will only look at a couple of the more common ones.

Confirmation bias - the tendency for individuals to selectively notice and process information that confirms their pre-existing beliefs while disregarding information that doesn’t.

• An example of confirmation bias is when a person believes share X is poised for high growth going forward and a news article is published with a mixed review of share X. The person reading the article will disregard the negative information and only remember the positives, thereby reinforcing their belief that the share will grow.

Anchoring and adjustment bias - assigning too much importance to original information.

• E.g. A person sees a share is priced at R 100 the first time they encounter the share and uses this as an anchor going forward. Any subsequent adjustments to the share price are based on the original price of R 100. This completely disregards whether the price of R 100 was a fair price for the share in the first place.

Emotional Biases

Cognitive biases, in general, are easier to correct than emotional biases. Emotional biases stem from intuition or impulse and as you can imagine it is a tall order to try and change the way you feel about something. As with cognitive biases there are a large variety identified and we will only look at the more common/problematic ones.

Loss aversion - one of the more common emotional biases. People with this bias tend to experience losses more acutely than gains. If, for instance, a client is presented with a 10% gain they would not experience the same amount of satisfaction as the pain they will experience when presented with a 10% loss. This is a common bias as it is routine for people to accept lower returns in exchange for a lower risk of losses.

• As this is a very broad bias present in most individuals the example will not cover all the different permutations.
• If an individual forgoes 4% in potential returns in order to ensure that a 1% possible loss is avoided the person can be said to be loss averse.

Endowment bias - the bias of overvaluing an asset just because it is already owned. This is particularly true in the case of inheritance. If you inherit an asset it is common to attach a sentimental premium to the asset. The correct action is always to ask yourself what you would do if this asset was received as cash. If your answer would be to buy the asset at its current price then you are right to hold, but if you wouldn’t necessarily pay as much to buy the asset you are holding it may be time to consider your options. The same line of thinking can be applied to any of your assets.

The above biases all lead people to make decisions that might not be considered rational or optimal. It is not necessarily bad to have these biases as it is a normal part of being human. What is important though, is to be aware of your biases and to know whether it is affecting your investment decision making in a negative way.

Kind Regards,

Stefan Keeve

Tel +27 21 914 4966
Fax +27 21 914 4912
Email info@seedinvestments.co.za

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Thu, 15 Oct 2015

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