DEFINITION of Bias
Bias is a human tendency that affects our behavior and perspective, based on predetermined mental notions and beliefs. There are conscious and unconscious biases. Conscious biases are tendencies toward behaviors and ways of thinking that a person is aware that they have. An unconscious bias is when a person's behavior is altered or influenced by a belief they aren't completely aware that they have. Biases appear across many areas of life and are extremely present in investing. When investors act on a bias, they do not explore the full issue and can be ignorant to evidence that contradicts their initial opinions.
The two main categories of investor bias are emotional bias and cognitive bias. Mitigating emotional biases can help to remove feelings from a transaction that are clouding the investor's judgment. Avoiding cognitive biases allows investors to reach an impartial decision based solely on available data.
BREAKING DOWN Bias
Biases come in both emotional and cognitive flavors. Emotional biases allow an investor's judgment to be clouded because of emotions. Cognitive biases cause investors to make poor decisions because of objective errors in their thinking or reasoning process.
Common Biases in Investing
Common biases plaguing investors include: representative bias, cognitive dissonance, home country bias, familiarity bias, mood and optimism, overconfidence bias, endowment effects, status quo bias, reference point and anchoring, law of small numbers, mental accounting, disposition effects, attachment bias, changing risk preference, media bias and internet information bias.
Example of Bias
For example, endowment bias is very common among investors. Endowment bias causes an investor to overestimate the value of an item simply because they own it. Often, if you ask a person who does not own an item what they think it is worth they will give you a lower figure than the person who actually owns the item. This is because the owner of the item thinks the item is special and therefore worth more. When this translates into investing, owners of a stock may hold a stock too long waiting for its price to reach a high level that isn't warranted. They might think the stock is worth more than it actually is because of endowment bias.