10 Most Common Biases affecting the Psychology of Investing

ConvergEx's Nick Colas has an interesting list of the “10 most common biases affecting the psychology of investing” (via the Zero Hedge)

1) Anchoring & Adjustment:  This combination occurs when initial information unduly influences decisions by shaping the view of subsequent information.  Once the “anchor” or initial information is set, there exists a bias for interpreting other information around the anchor.  Car salesmen frequently use this tactic when presenting an initial sales price, making the subsequent negotiated prices seem lower than the initial price even though they are still higher than what the vehicle is actually worth.

2) Attribution Asymmetry: The concept here involves people’s tendency to attribute success to internal characteristics (such as talent and innate abilities) and to attribute failures to external factors (like simple bad luck).  Research has shown the reverse to be true when evaluating the successes and failures of others.  The lesson here is most valuable when you hit a “hot streak.”  When you experience speed bumps, don’t be quick to write them off as poor luck – there could be a fundamental problem with your strategy.

3) Choice-Supportive Bias:  By distorting recollections of chosen courses of action versus the rejected courses of action, people tend to make the chosen outcomes seem more attractive that the foregone ones.  Just as people more frequently remember “good” memories than they do “neutral” or “bad” memories, the belief that “I chose this option therefore it must have be superior” can lead to a false recollection of the ultimate outcome.  Learn from your mistakes – don’t forget them.

4) Cognitive Inertia: This is just psychological speak for the unwillingness to change thought patterns in light of new circumstances.  Quite simply, do your homework and keep up on your investments.  If a company slashes guidance, for example, perhaps you should consider altering your investment accordingly.

5) Incremental Decision Making & Escalating Commitment:  These biases occur when people view a decision as a small step within a larger process, rather than as a singular choice.  As a result, this viewpoint perpetuates a series of similar decisions, when perhaps many of those decisions should be evaluated with a fresh mind.

6) Group Think: Grown-up lingo for peer pressure, group think occurs when one feels compelled to adhere to opinions held by a larger group.  This one’s easy – don’t let others sway your opinion.  Groups tend to form a singular opinion based on the opinion of the loudest or most influential person in the group.  Doesn’t mean he’s right.

7) Prospect Theory: This theory explains that people are more likely to take on risk when evaluating potential losses; though in looking at potential gains, humans have the tendency to be risk-averse.  In other words, losses feel worse than gains feel good.

8) Repetition Bias: The bias results from the willingness to believe what one has been told most often and by the greatest number of different sources.  Remember all the hoopla over Facebook’s IPO?  And then its year one performance?  Yeah, everybody though it was a hot stock and only now has it drifted above its IPO price.

9) Sunk-Cost Fallacy: If someone makes a decision about a current situation, based all or in part on what they have previously invested (money, time or otherwise) in the situation, they are suffering from sunk-cost fallacy.  Not matter how much you’re down on an investment, if it’s likely to never be recovered, then cut your losses and let it go.

10) Wishful Thinking: This “problem” happens when people are too optimistic; wanting to see things in a positive light can distort perception and objective thinking.  Just because you really really really want your investment to appreciate, doesn’t mean it will.  Investing should not be treated as gambling.

I would 10 more to this list

1.confirmation bias—search for information that confirms on embedded beliefs rather than objective analysis (related to selective perception)

2.endowment effect—ascribing more value on things or ideas that are owned or possessed (related to sunk-cost)

3.optimism bias—the tendency for people to believe that bad things will happen to everyone else but them (Nassim Taleb calls this the denigration of history)

4.regret theory—reaction to opportunity loss (I should have done this…)

5.status quo bias—preference for the status quo, rejection of change

6.clustering illusion—the tendency to see patterns where there is none or the intuition for pattern seeking

7.gambler’s fallacy--mistaken belief that if something happens more frequently than normal during some period, then it will happen less frequently in the future or (Nizkor) a departure from what occurs on average or in the long term will be corrected in the short term

8.confusing cause and effect

9.hindsight bias the presumption of knowledge from something that has already occurred or the “knew-it-all-along effect”

10.survivorship bias—tendency to focus on winners while overlooking the others due to lack of visibility

I wrote about “The Psychological Impact of an Inflationary boom” here.

Cognitive biases and heuristics signify as the "law of least effort"- the tendency to desire more rewards with lesser efforts or costs. 

As Nobel Prize psychologist and author Daniel Kahneman, wrote in Thinking, Fast and Slow (p.35) 

A general “law of least effort” applies to cognitive as well as physical exertion. The law asserts that if there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action. In the economy of action, effort is a cost, and the acquisition of skill is driven by the balance of benefits and costs. Laziness is built deep into our nature.