Understanding Common Types of Bias in Investing

What Is Bias?

Bias is an illogical or irrational preference or prejudice held by an individual, which may also be subconscious. It's a uniquely human foible, and since investors are human, they can be affected by it as well. Psychologists have identified more than a dozen kinds of biases, and any or all of them can cloud the judgment of an investor.

Key Takeaways

  • Bias is an irrational assumption or belief that affects the ability to make a decision based on facts and evidence.
  • Investors are as vulnerable as anyone to making decisions clouded by prejudices or biases.
  • Smart investors avoid two big types of bias—emotional bias and cognitive bias.

Understanding Bias

Besides warping the ability to make a decision based on facts and evidence, bias is also a tendency to ignore evidence that doesn't line up with that assumption.

A bias can be a conscious or unconscious mindset. When investors take biased action, they fail to acknowledge evidence that contradicts their assumptions.

Smart investors avoid two major types of bias: emotional and cognitive. Controlling them can allow the investor to reach a decision based on available data.

Relying on bias rather than hard data can be costly.

Common Biases in Investing

Psychologists have identified a number of types of bias that are relevant to investors:

  • Representative bias may lead to snap judgments because of a situation's similarities to an earlier matter.
  • Cognitive dissonance leads to an avoidance of uncomfortable facts that contradict one's convictions.
  • Home country bias and familiarity bias lead to an avoidance of anything outside one's comfort zone.
  • Confirmation bias describes how people naturally favor information that confirms their previously existing beliefs.
  • Mood bias, optimism (or pessimism) bias, and overconfidence bias all add a note of irrationality and emotion to the decision-making process.
  • The endowment effect causes people to over-value the things they own just because they own them.
  • Status quo bias is resistance to change.
  • Reference point bias and anchoring bias are tendencies to value a thing in comparison to another thing rather than independently.
  • The law of small numbers is the reliance on a too-small sample size to make a decision.
  • Mental accounting is an irrational attitude towards spending and valuing money.
  • The disposition effect is the tendency to sell investments that are doing well and hang onto losers.
  • Attachment bias is a blurring of judgment when one's own interests or a related person's interests are involved.
  • Changing risk preference is the gambler's fatal flaw: a small risk, no matter what the outcome, creates a willingness to take on greater and greater risks.
  • Media bias and Internet information bias represent uncritical acceptance of widely-reported opinions and assumptions.

Example of Bias

Bias can be seen in the way people invest. For example, endowment bias can lead investors to overestimate the value of an investment simply because they bought it. If the investment is losing money, they insist they're right and that the market will surely correct its error. They may reinforce this belief by reviewing all of the reasons it was worth what they paid, ignoring the reasons its value fell. The rational investor would review all of the data, positive and negative, and decide whether it's time to take the loss and move on.