2 Introduction to Behavioral Biases

      Nothing in life is quite as important as you think it is while you're thinking about it.

      —Daniel Kahneman

Introduction

In order to create your best portfolio, it is essential that you obtain an understanding of the irrational behaviors that you have—or be able to recognize the biases of others that may be involved in your investment decision-making process. Numerous research studies have shown that when people are faced with complex decision-making problems that demand substantial time and cognitive decision-making requirements, they have difficulty devising a rational approach to developing and analyzing a proper course of action. This problem is exacerbated by the fact that many consumers need to contend with a potential overload of information to process. Have you walked down the shampoo aisle lately? Way too many choices—how do you pick? And this is one of the easier decisions we face! When it comes to our money, it becomes even more complicated. For more meaningful decisions, people don't systematically describe problems, record necessary data, and/or synthesize information to create rules for making decisions, which is really the best way to make complex decisions. Instead, people usually follow a more subjective path of reasoning to determine a course of action consistent with their desired outcome or general preferences.

      Individuals make decisions, although typically suboptimal ones, by simplifying the choices presented to them, typically using a subset of the information available, and discarding some (usually complicated but potentially good) alternatives to get down to a more manageable number. They are content to find a solution that is “good enough” rather than arriving at the optimal decision. In doing so, they may (unintentionally) bias the decision-making process. These biases may lead to irrational behaviors and flawed decisions. In the investment realm, this happens a lot; many researchers have documented numerous biases that investors have. This chapter will introduce these biases, which we will review in the coming chapters, and highlight the importance of understanding them and dealing with them before they have a chance to negatively impact the investment decision-making process.

Behavioral Biases Defined

      The dictionary defines a “bias” in several different ways, including: (a) a statistical sampling or testing error caused by systematically favoring some outcomes over others; (b) a preference or an inclination, especially one that inhibits impartial judgment; (c) an inclination or prejudice in favor of a particular viewpoint; and (d) an inclination of temperament or outlook, especially, a personal and sometimes unreasoned judgment. In this book, we are naturally concerned with biases that cause irrational financial decisions due to either: (1) faulty cognitive reasoning or (2) reasoning influenced by emotions, which can also be considered feelings, or, unfortunately, due to both. The first dictionary definition (a) of bias is consistent with faulty cognitive reasoning or thinking, while (b), (c), and (d) are more consistent with impaired reasoning influenced by feelings or emotion.

Behavioral biases are defined, essentially, the same way as systematic errors in judgment. Researchers distinguish a long list of specific biases and have applied over 100 of these to individual investor behaviors in recent studies. When one considers the derivative and the undiscovered biases awaiting application in personal finance, the list of systematic investor errors seems very long indeed. More brilliant research seeks to categorize these biases according to a meaningful framework. Some authors refer to biases as heuristics (rules of thumb), while others call them beliefs, judgments, or preferences. Psychologists' factors include cognitive information processing shortcuts or heuristics, memory errors, emotional and/or motivational factors, and social influences such as family upbringing or societal culture. Some biases identified by psychologists are understood in relation to human needs such as those identified by Maslow—physiological, safety, social, esteem, and self-actualizing. In satisfying these needs, people will generally attempt to avoid pain and seek pleasure. The avoidance of pain can be as subtle as refusing to acknowledge mistakes in order to maintain a positive self-image. The biases that help to avoid pain and instead produce pleasure may be classified as emotional. Other biases are attributed by psychologists to the particular way the brain perceives, forms memories, and makes judgments; the inability to do complex mathematical calculations, such as updating probabilities; and the processing and filtering of information.

      This sort of bias taxonomy is helpful as an underlying