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Who's influenced by behavioural biases? Everyone

Sarwari Das  |  27 May 2021Text size  Decrease  Increase  |  
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Overconfidence and impatience are usually a bad combination. In investing, it can be destructive.

Take the case of Robinhood. In reference to the short-selling squeeze that gripped investors on Robinhood and similar platforms a month ago, Berkshire Hathaway (BRK.B) vice chairman Charlie Munger stated that it was irresponsible “to have a culture which encourages [so] much gambling in stocks by people who have the mindset of racetrack bettors and, of course, it will create trouble, as it did.”

Around the same time, Robinhood aired its infamous TV commercial at Superbowl LV that stated plainly: “You don’t need to become an investor. You were born one.”

But the trouble is that we aren’t born to be investors. At least, not good ones.

Effective investing doesn’t come naturally to most of us. Even when we know the fundamentals, we tend to make snap decisions and irrational--sometimes destructive--mistakes, based on what “feels” right. The gamification built into platforms like Robinhood—free stock for signing up, frequently updating and colourful screens based on performance, even digital confetti upon completion of a successful transaction—may at times, just worsen these tendencies.

In a study we conducted on a nationally representative sample of the U.S population, we found evidence that although most Americans are overconfident (67 per cent of the sample), people currently in Generation Z are significantly more overconfident—even more than millennials and Gen Xers. We also know that Robinhood’s average user is 31 years old, and half of them are first-time investors. This premise of innate investing knowledge, combined with a platform that rewards hasty decisions with immediate gratification and self-flattery, makes for a breeding ground of biased decisions.

In The Financial Impact of Behavioural Biases, we further explored this topic to unpack the specifics about who’s subject to certain biases. Now, more than ever, it’s important to understand these investor biases—what they are, how they affect us, and what we can do to avoid them.

Who exhibits behavioural biases?

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In our research, we found that nearly all respondents showed signs of multiple investor biases—with a staggering 98 per cent of the sample exhibiting at least one bias. Specifically:

  • 97 per cent of the sample presented a tendency to prioritise their present intentions over long-term goals (present bias);
  • 82 per cent of the sample showed signs of ignoring base rates while making decisions involving probability (base rate neglect); and
  • 65 per cent of people displayed signs of having stronger responses to losses than equivalent gains (loss aversion).

Interestingly, we also found demographic factors that could help dispel some common misperceptions about these behavioural biases. Our overconfidence result stating that younger people tend to be more overconfident is the only strong example of a demographic difference. Otherwise, for example, we found no statistically significant differences in most biases between genders, indicating that one gender is not "more biased" than the other.

What investor biases mean for our finances

We know now that investor biases are not an anomaly, and we shouldn’t underestimate their power.

Our research explored the different ways in which they could affect our lives, finding that individual level differences in bias scores were strongly correlated with real-world outcomes like financial health, net worth, saving and spending habits, and so on.

For instance, compared with people with low bias, people who showed high levels of overconfidence were twice as likely to be struggling with their financial lives: having the lowest savings, the highest debt, and the worst credit scores. These results hold true for most of our behavioural biases and can even be translated to real-life account balances: For example, while controlling for age and income, with a standard deviation increase in base rate neglect scores, credit card debt amounts increased by 0.18 per cent (p<0.05) on average, while savings account balances fell by 0.55 per cent (p<0.001) on average.

One explanation of biases’ correlation with fewer assets is that a person’s biases are manifesting in detrimental financial behaviour. For example, we found that when compared with people with high present bias, people with low bias are:

  • 7.5 times more likely to plan ahead for their future,
  • 2.4 times more likely to pay bills on time, and
  • 2.8 times more likely to spend less than their income.
  • All these results were significant at p<0.05.

This held true for other behavioural biases as well. People with high overconfidence were 3.33 times less likely to save for retirement (p<0.05), while people with low base rate neglect are 2.85 times more likely to save for emergencies (p<0.001).

Interestingly, we also found that, at times, behavioural bias measures are better correlated with financial outcomes than these traditional predictors of financial health. A person’s level of education, for instance, has a 27 per cent correlation with their financial health (p<0.001). In contrast, overconfidence and base rate neglect scores have a negative 33 per cent (p<0.001) and negative 45 per cent (p<0.001) correlation with financial health.

What about advisers' behavioural biases?

It’s clear that our biases hurt us. So, who do we turn to for help? One of the big challenges we face in helping overcome investors’ biases is that we think they only apply to them—they really apply to all of us. In a review of the literature from Russo & Schoemaker and Cooke, we found that experts suffer from a similar overconfidence: Self-confidence outstrips expertise.

This holds for advisors and investing. In a study conducted on advisers' biases, researchers found that:

82 per cent of advisers reported that they felt loss aversion, which may make them more likely to sell winners too early and hold on to losers for too long;

65 per cent of advisors also showed signs of overconfidence or believing that their portfolio management skills would allow them to outperform the market.

So, while it’s true that investors are susceptible to behavioural biases, it seems that advisors aren’t immune either.

Bias, bias everywhere

We’re all a little biased. When it comes to our finances, we’ve found that they can do real harm. More importantly, it’s always possible that biases can have a broad impact on the way we think about the world around us. We must, investors and advisors alike, recognize biases for what they are and take active steps to avoid them in our financial lives

is a behavioral researcher with Morningstar.

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