• / Free eNewsletters & Magazine
  • / My Account
Home>Practice Management>Practice Builder>The 5 Biases of Independent-Minded Investors

Related Content

  1. Videos
  2. Articles
  1. Social Security: Your Questions Answered

    Retirement experts Mary Beth Franklin and Mark Miller tackle viewers' most pressing questions on this very important, yet also contentious, retirement pillar--Social Security.

  2. Give Your Portfolio a Checkup

    Morningstar's Christine Benz shows you how to uncover portfolio strengths and weaknesses, determine the impact of market movements on your asset mix, and more.

  3. Practical Strategies for Today's Bond Market

    The outlook for bonds is just as cloudy as ever, but Morningstar's Miriam Sjoblom and Marta Norton offer helpful tips for setting the right expectations and creating a game plan in today's challenging bond market.

  4. Keep Up With Your College-Savings Homework

    Families of future and current college students should be mindful of the effects of sequestration, a university's 'Scorecard,' their own savings projections, and their future debt loads.

The 5 Biases of Independent-Minded Investors

Overemphasizing data that confirms your beliefs and over-reliance on readily available information top the list.

Michael M. Pompian, 09/18/2014

This month's article is the ninth in a series called "Deep Dives Into Behavioral Investor Types." This series is intended to help advisors create better relationships with their clients by deeply understanding the type of person they are dealing with from a financial perspective and being able to adjust their advisory approach to each type of client.

As we learned in the last series, there are four behavioral investor types, or BITs: the Preserver, the Follower, the Independent, and the Accumulator. As noted in previous articles, the learning process for each BIT will be a series of three articles:

1. Part I will be a diagnosis of each BIT and discussion of its general characteristics.

2. Part II will be a deep dive into the biases of each BIT.

3. Part III will be how to create a portfolio for each BIT.

This article is Part II of the Independent BIT.

 

As previously reviewed, the biases of Independents tend to be cognitive--relating to how people think--rather than focusing on emotional aspects--relating to how they feel. The biases of the Independent BIT are confirmation, availability, self-attribution, conservatism, and representativeness.

I have found that two biases have a substantial impact on Independent behavior: confirmation and availability.

Confirmation Bias
Bias Type: Cognitive

People tend to want to stand by the decisions they make. It's human nature. And because it makes us feel good to believe we've made the right decisions, we also tend to notice those things that support our decision and opinions, and ignore those things that may contradict them. That's the essence of confirmation bias. It convinces us that what we want to believe is correct by mentally giving more weight to the factors that support our desired outcome.

This behavior can be hazardous to our wealth because we can get blindsided by information that we did not consider. Confirmation bias affects the investor by making an investment decision appear better than it actually is.

Here's an example from the last investing cycle: Suppose your client Jack, who is 43 and single, was an aggressive accumulator of real estate in the 2000s. Over these years, he had seen condominium complexes and strip malls sprout up, and get bought up, and for that reason he believed that real estate would be his ticket to riches. His confirmation bias had been enforced year after year, as real estate prices soared and as banks loaned money for new projects without limit. But his confirmation bias clouded his judgment. It caused him to block out potential pitfalls and focus only on the good aspects of his investment.

Watching the construction industry move like it was never going to slow down, he devoted most of his portfolio to real estate and new construction, with little diversification in other areas. Like many people, he saw only the upside of the real estate boom; he didn't see it as a bubble that would eventually burst. Despite advice to the contrary, Jack held too much in real estate investments.

Because investors with confirmation biases tend to seek out only information that confirms their beliefs about investments they have made, or are about to make, they don't grasp the full picture, like Jack. He may have been peripherally aware that bad loans were being made and that the inventory of new developments was starting to outstrip the demand--both factors that should have been as valid in informing his decisions as the others. But he was able to talk himself out of their importance to his ultimate detriment.

Availability Bias
Bias Type: Cognitive

Another bias that weighs heavily on the investment decisions of the Independent is availability bias. Availability makes investors believe that the facts most relevant to their own lives are the ones most relevant to the success of an investment. How "available" a piece of information is to them thus somehow determines how reliable it is. When we have an availability bias, possibilities that we can easily recall and those that we are most familiar with seem more likely to be true than those that are less familiar.

It's difficult to properly process all the information that comes at us every day. For that reason, we process bits of information we can easily identify and swallow, and we ignore the rest. When it comes to investing, this behavior usually translates into making judgments based on past experiences and easily perceived outcomes, instead of taking in harder-to-grasp data, like statistics.

Some people put a subjective slant on information instead of looking objectively at the cold, hard facts. A classic example is choosing to invest with brokers or mutual fund firms that do the most advertising. These firms make information available and people buy them--but are they the best? Diligent research might prove otherwise.

Availability bias can be broken down into four categories: retrievability, categorization, narrow range of experience, and resonance. These are each different twists on the same idea, but each is relevant in its own way. (More information on these four areas can be found in my book Behavioral Finance and Wealth Management.)

Confirmation and availability are two highly impactful biases for Independents. However, other biases can be found to occur with Independent BITs with some regularity, including self-attribution, conservatism, and representativeness.

Self-Attribution Bias
Bias Type: Cognitive

When a decision we make works out nicely, we like to attribute the success to our own talents and foresight. When things don't turn out as planned, we like to blame bad luck and other circumstances that are out of our control.

If you score a high mark on a test, do you believe this is a direct result of your hard work and innate intelligence? And if you do poorly, do you blame the grading system of even the test? If you have a tendency to believe your successes have everything to do with your talents and abilities, and that your failures are never a result of your own shortcomings, then you probably harbor a self-attribution bias.

When Independent BITs' financial decisions pan out well, they like to congratulate themselves on their shrewdness. When things don't turn out so profitably, however, it consoles the Independent BIT to conclude that someone or something else is at fault. Neither is entirely correct.

Often when things work out well and people with a self-attribution bias assess their portfolios, they end up having more confidence in their stock-picking abilities than is actually warranted--and, as a result, they may end up taking on more risks than they should. You've heard the phrase, "a little knowledge is a dangerous thing"? In investing, it can be very painful. Winning investment outcomes are typically due to any number of factors--a bull market being the most prominent. A decline in value, meanwhile, can be equally random and complex. (Sometimes it is due to fraud or mismanagement; sometimes it's luck.)

Because they believe they have more control over these outcomes than is warranted, people with a self-attribution bias are consumed by the pride that surges when trades do well, and because they do not take a step back to figure out what they could have done wrong when trades don't do well, they tend to trade too often, resulting in a portfolio that underperforms.

Conservatism Bias
Bias Type: Cognitive

Independent BIT investors with a conservatism bias tend to cling to what they already know to be true at the expense of acquiring new information. For instance: Suppose an investor named James receives some bad news regarding a company's earnings, which contradicts another earnings estimate from the month prior that he relied on to invest in the company. Because he has a conservatism bias, James underreacts to the new information, holding on to the original estimate instead of acting on the updated information. As a result, he ends up holding on to a stock that he's going to lose money on because he refuses to see that he could. Like James, people with conservatism bias can make bad investment decisions because they are stuck in their prior beliefs.

Representative Bias
Bias Type: Cognitive

The last bias that can be attributed to Independents is representative bias. Like availability bias, the representative bias is strongly rooted in our desire to have the information we need to process fit into a neat framework. But representative bias takes this tendency a step further, in that when people who harbor a representative bias encounter elements that don't fit into their categories, they try a "best fit" approach.

On the plus side, representative bias helps us quickly absorb and process new information. On the downside, it works against us as it only allows us to perceive those probabilities that fit into the framework of what we want to perceive.

Think of the gambler on a winning streak. Statistically, there is no such thing as a winning streak, but try telling the gambler that when the odds seem to be working in his favor. The gambler sees winning hand after winning hand, and forces this into a framework he can understand--the winning streak.

The lesson here is that when investors don't see the whole picture, they are prone to make false assumptions based only on a few bits of available data, and they ascribe universal generalities to this small cross-section of information. In investing, this could mean making investments that are headed south without realizing it, which is more common than you think. Always look at a full set of data when making decisions so this won't happen to you.

Next month will be the 10th article in the "Deep Dives Into Behavioral Investor Types" series, and the third on the Independent BIT. 

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

blog comments powered by Disqus
Upcoming Events
Conferences
Webinars

©2014 Morningstar Advisor. All right reserved.