Understanding Common Types of Bias in Investing

What Is Bias?

In investing, the term “bias” refers to an irrational assumption or belief that warps an investor’s ability to make a decision based on facts and evidence.

Investors face two significant bias challenges: emotional and cognitive. Emotional biases typically involve spontaneous decisions based on personal feelings and other psychological factors, while cognitive biases involve decisions based on established concepts that may or may not be accurate. Recognizing and managing both biases lead to better investment decisions.

Read on to learn about the more than a dozen types of bias psychologists have found, such as confirmation bias, representative bias, and status quo bias, that can cloud an investor’s judgment. Bias may be subconscious as well as irrational. It’s a uniquely human foible, and since investors are human, they can be affected by it as well.

How Bias Affects Investment Decisions

Bias not only distorts decision-making based on facts but also ignores evidence that contradicts its assumptions. Bias can be conscious or unconscious. When investors act on it, they ignore evidence contradicting their beliefs.

Smart investors avoid emotional and cognitive biases, allowing decisions based on available data.

Top Investment Biases to Avoid

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

• Representative bias can cause snap judgments based on a situation’s similarity to a past event.
• Cognitive dissonance leads to an avoidance of uncomfortable facts that contradict one’s convictions.
• Illusion of control bias is a cognitive belief where investors overestimate their ability to influence outcomes.
• 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.
• Three types of bias—mood, optimism or pessimism, and overconfidence biases—add emotion and irrationality to decision making.
• The endowment effect makes people overvalue their possessions solely because they own them.
• Status quo bias is resistance to change.
• Outcome bias assumes a future result will happen based on previous events without regarding how those past events developed.
• 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.

Real-World Bias: Investing Errors to Watch Out for

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 loses money, they insist they’re right and the market will surely correct its error. They may reinforce this belief by reviewing all the reasons it was worth what they paid, ignoring why its value fell. An investor with implicit bias might bypass an otherwise profitable investment based on negative biases about where the company is located or its stance on public issues.

Rational investors review all positive and negative data to make objective investment decisions.

The Bottom Line

Bias is an irrational assumption or belief that affects the ability to make a decision based on facts and evidence. Bias in investing can cloud judgment and lead to poor decisions.

Recognizing and controlling cognitive and emotional biases leads to rational, data-driven investment decisions. Also, understanding and addressing common biases—types include confirmation bias, the endowment effect, and home country bias—can improve investment outcomes.

Investors should continuously review all available evidence, both positive and negative, to avoid being influenced by bias. Striving for objectivity and maintaining skepticism of widely reported opinions should improve investors’ decision making.