The ABCs of Behavioral Biases: Part II

published by:
AMANDA CLOUSER, CFA, CFP®
May 18, 2020

The ABCs of Behavioral Biases: Part II (A-F)

Welcome back to our “ABCs of Behavioral Biases.” Today, we’ll get started by introducing you to four self-inflicted biases that knock many investors off-course: anchoring, blind spot, confirmation, and familiarity bias.

Anchoring Bias

What is it? Anchoring bias occurs when you fix on or “anchor” your decisions to a reference point, whether or not it’s a valid one.

When is it helpful? An anchor point can be beneficial when it is relevant to living more efficiently. For example, in his book, “The Behavioral Investor,” Daniel Crosby describes: “When you meet someone new, you begin forming opinions of them within seconds. These first impressions, or anchors, then set the guardrails within which future impressions tend to fall.” As long as your assumptions hold true, they can speed things along next time you encounter the same individual.

When is it harmful? In investing, people often anchor on the price they paid when deciding whether to sell or hold a security: “I paid $11/share for this stock, and now it’s only worth $9/share. I’ll hold off selling it until I’ve broken even.” As Evidence-based investing informs us, the best time to sell a holding is when it’s no longer serving your ideal portfolio, as prescribed by your investment plans. What you paid is irrelevant to that decision, so anchoring on that arbitrary point creates a dangerous distraction.

Blind Spot Bias

What is it? Blindspot bias occurs when you can objectively assess others’ behavioral biases, but you cannot recognize your own.

When is it helpful? Blindspot bias helps you avoid over-analyzing your every imperfection, so you can get on with your one life to live. It lets you tell yourself, “I can do this,” even when others may have their doubts.

When is it harmful? It’s hard to root out all your deep-seated biases once you’re aware of them, let alone the ones you remain blind to. In “Thinking, Fast and Slow,” Nobel laureate Daniel Kahneman describes (emphasis ours): “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Hint: This is where second opinions from an independent advisor can come in especially handy.)

Confirmation Bias

What is it? We humans love to be right and hate to be wrong. This manifests as confirmation bias, which tricks us into being extra sympathetic to information that supports our beliefs and especially suspicious of – or even entirely blind to – conflicting evidence.

When is it helpful? When it’s working in our favor, confirmation bias helps us build on past insights to more readily resolve new, similar challenges. Imagine if you otherwise had to approach each new piece of information with no opinion, mulling over every new idea from scratch. While you’d be incredibly open-minded, you’d also be excessively indecisive.

When is it harmful? Once we believe something – such as an investment is a good/bad idea, or a market is about to tank or soar – we want to keep believing it. To remain convinced, we’ll tune out news that contradicts our beliefs and tune into that which favors them. We’ll discount facts that would change our minds. We’ll find false affirmation in random coincidences, and justify fallacies and mistaken assumptions that we would otherwise recognize as inappropriate. And we’ll do all this without even knowing it’s happening. This bias can influence even stock analysts.

Familiarity Bias

What is it? Familiarity bias is another mental shortcut we use to trust more quickly (or more slowly reject) an object that is familiar to us.

When is it helpful? Do you cheer for your home-town team? Speak more openly with friends than strangers? Favor a job applicant who (all else being equal) has been recommended by one of your best employees? Congratulations, you’re making good use of familiarity bias.

When is it harmful? Considerable evidence tells us that a broad, globally diversified approach best enables us to capture expected market returns while managing the risks involved. Yet studies like this one have shown investors often instead overweight their allocations to familiar vs. foreign investments. We instinctively assume familiar holdings are safer or better, even though we can’t all be correct at once. We also tend to be more comfortable than we should be bulking up on our employer’s company stock.

Ready to learn more? Next, we’ll continue through the alphabet, introducing a few more of the most suspect financial behavioral biases.

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