Behavorial Biases

Behavioral Biases

Behavioral biases result in irrational financial decisions. Learn more about different biases and how they influence you in the decision making
process and apply your knowledge while investing into cryptocurrencies.

Loss aversion refers to our tendency to strongly prefer avoiding losses over acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. For example, when making investment decisions we most often focus on the risks, which are associated with the investment rather than on the potential gains. Consider following scenarios:
Imagine you are offered to choose between two cryptocurrency investment options. Which would you choose?

Option 1: A 50% chance of gaining €1000 and gaining nothing.
Option 2: A 50% of chance of losing €1000 and gaining €400.

And Now?

Option 1: A 50% chance of losing €1000 and gaining nothing.
Option 2: A 50% chance of gaining €1000 and loosing €400.

In the first scenario, we have:
● Lottery 1 has an expected value of €50
● Lottery 2 has an expected value of €100

In the second scenario, we have:
● Lottery 1 has an expected value of – €50
● Lottery 2 has an expected value of – €100

NB! Investors with low risk profiles tend to feel the pain of losses more than the pleasure of gains as compared with other investor types. As a result, these investors might hold losing investments too long, even when there is no prospect of a turnaround.

Loss aversion comes from our natural motive to prefer avoiding losses rather than achieving similar gains. We cannot eliminate loss aversion, but by being aware of that we will know how to achieve more. can be aware of it. Let our awareness not only prevent us from making irrational decisions but also help us to achieve more.

The hard coding in our brains that creates the endowment effect is difficult to change. Our preference for avoiding loss and pain over seeking pleasure is a basic instinct that has evolved over time. In our ancient past, avoiding loss and pain was a useful skill — it was critical to merely surviving. Today, this instinct helps us more in making quick decisions and preserving our mind power for more analytical tasks.

Status Quo reflects our emotional preference for the current situation. Many of us tend to resist change and prefer the current state of affairs.

Other cognitive biases interact with the status quo bias. For example, the endowment effect, when we value things more simply because we own it, can contribute to the status quo bias. If an item is worth more to you because you own it, you are less likely to part with it.

Loss aversion also contributes to the status quo bias. Our fear of losing money is greater than our satisfaction from gaining money. Because we’d rather keep what we have rather than take a chance at losing money, we tend to stick with the status quo.

Investors with low risk profile often like to keep their investments the same or in other words to keep the "status quo." These investors tell themselves "things have always been this way" and feel safe keeping things the same.

The endowment effect describes our irrational tendency to overvalue something just because we own it. The difference in value happens because we possess the item and feel comfortable with it. In other words, we might build a personal connection with the item and do not want to give it up at no price.

There are two psychological reasons, which lead to endowment effect:
● Loss aversion – we feel the pain of loss twice as strongly as we feel pleasure from an equal gain.
● Ownership – we get attached to what we already have and we are ready to pay more to keep something that we already own than we would pay for an item we don’t own.

The hard coding in our brains that creates the endowment effect is difficult to change. Our preference for avoiding loss and pain over seeking pleasure is a basic instinct that has evolved over time. In our ancient past, avoiding loss and pain was a useful skill — it was critical to merely surviving. Today, this instinct helps us more in making quick decisions and preserving our mind power for more analytical tasks.

NB! ! Investors with low risk profile, and especially the ones, who inherit wealth, tend to assign a greater value to investments that they already own (such as a piece of real estate or an inherited stock position) than they would if they don't possess that investment and have the potential to acquire it.

Conservative investors often avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause conservative investors to be too timid in their investment choices because of losses they have suffered in the past.

Anchoring is a bias, which describes our common tendency to rely too heavily, or "anchor," on one piece of information when making decisions.

The most classic anchor is a previous price. For example, can you recall having heard someone saying “I’m waiting for the share price to fall to last weeks/months/years price before I buy” or “I’m waiting for my position in investment X to get back to break-even to sell”. Both of these cases investors are being tied to irrelevant price anchors.

Our daily life example: The price of the most expensive meal on a menu often serves as an anchor to influence perceptions of other meals on the menu (as relatively cheap).

Investors having low risk profile are often influenced by purchase or arbitrary price levels. They tend to cling to these numbers and frequently will resist selling until its price rebounds to the initial price they have anchored to.

Recency bias refers to the tendency of the people to recall and emphasize recent experiences. In other words, it would make you think that what’s been happening lately will keep happening.

Recency bias can cause you keep holding in crypto currencies because they have been performing well, believing that they would gain continuously, despite the clear warning signs of downward trend. On other side, it can also keep you away from buying crypto currencies, when their prices are low, because the prices have been dropping for months and under Recency Bias you would expect them to keep falling.

Hindsight bias refers to the tendency to view events as being more predictable than they really are. The problem is that often we actually didn’t know it all along, we only feel as we did. This bias can also make us overconfident in how certain we are about our own judgments.

In the investment domain it would show itself as a reaction of the investors to any information as if they were aware of that before this information has been communicated. As a result, hindsight bias is giving to the investors a false sense of security when making investment decisions, encouraging them to take excessive risk without understanding that.

Framing bias is the tendency of people to respond to situations differently based on the context in which choices are presented (framed).

The way a question is “framed” often has an influence on how we answer that question. Consider following scenarios, which strategies would you pick?

You are analyzing different investment strategies

Scenario 1

Strategy 1: 200 people in the town will be saved
Strategy 2: There is a 1/3rd probability that 600 people will be saved, and a 2/3rds probability that no people will be saved.

Scenario 2

Strategy 3: 400 people in the town will die
Strategy 4: There is a 1/3rd probability that nobody will die, and a 2/3rds probability that 600 people will die.

In terms of risk and the respective proportion of losses and gains, the scenarios are identical: Strategy 1 and 3 are same as Strategy 2 and 4. However, most people chose strategy '1' and '4' respectively, only because they have been presented differently.

Majority of people are loss averse, meaning that they prefer to avoid losing twice as much than they enjoy winning. Strategy 2 and 3 activate the loss aversion while Strategies 1 & 4 are framed in the positive way.

Cognitive Dissonance describes the feeling of mental discomfort we experience when trying to keep two conflicting beliefs.
We will go a great length to convince ourselves that decision we took was the right one, in order to avoid discomfort which arises with the wrong decision.

There are two kinds of cognitive dissonance bias:

Selective perception, when we only register information that appears to affirm our choice.
Selective decision making, when we rationalize our actions in order to stick to an original plan.

Cognitive Dissonance can make us reluctant to sell the losing positions of our investment or review the positions that no longer look as appealing as before. It will also stop us from reading markets objectively and will restrain us from adapting fast to the changing conditions.

Ambiguity aversion refers to tendency of people prefer known risk to unknown risks. Experiments show that people avoid uncertainty even when it is small and such ambiguous options have higher expected value.

When it comes to the investment domain, then even when some investors feel skillful or knowledgeable, they may not be willing to take risk on "ambiguous" investments, even though they believe they could predict these outcomes based on their own judgment.

The illusion of control bias occurs when we believe that we can control or at least influence outcomes, when in reality, luck, chance or other factors played a large role.

In the investment decision making this bias leads us to believe that the best way to manage our investment portfolio is to constantly adjust it, which in turn will lead to improper diversification.

Illusion of control is manageable, psychologist Gary Klein has invented a technique to evaluate major decisions, which he calls “ remortem”. The idea of it is very simple: imagine yourself in the future, after the project you're considering has ended in spectacular failure. In the imaginary world of the premortem, your venture is already over. You're screwed. Everything went as badly as you could have feared. Now: why? Work backwards from there and think of possible ways why the failure might have occurred.

According to Klein asking the question this way has an almost magical effect. It removes the pressure from people who were worried about seeming disloyal by speaking out loud about concerns; instead, it turns things into a competition to find more convincing reasons for failure.

Overconfidence bias can be best described as a tendency to overestimate our own knowledge, skill, or judgment. This tendency can lead to poor decisions as in our day-to-day life as well as investing.

Overconfidence can lead to excessive trading and underestimation of the downside risk related to the investment. Apart from that it can also make us neglect negative information about the investment as well as lead to undiversified portfolio.

Revisiting investment decisions on a regular basis, setting realistic expectations, disciplined investment strategy may help to counter overconfidence.

Availability bias refers the situation when our decisions are influenced by most recent or vivid information. It can also lead us to overreact based on this information as it is fresh in our minds.

As an example, imagine you decided to google for the best crypto currencies to invest in 2018 and you will find article outlining 10 crypto currencies which have lately made the buzz in the market. Should you be prone to availability bias you most likely be influenced to pick crypto currencies of the projects mentioned in this article, even though some of the most promising crypto currencies did not show up in you search.

To reduce the likelihood of availability bias playing a role in your investment decisions, try to seek for extra information, make a wide research and question commonly accepted views.

When we are faced with uncertainty while making a decision, we often rely on a mental shortcut or "rules of thumb" known as the representativeness heuristic.

The representativeness heuristic is a decision-making shortcut that uses our past experiences to help us to make a decision quickly and efficiently. When we are confronted with a new situation and need to make a choice or decision, our brain automatically relies on our previous experience as well as mental representations, which look very much similar to this new situation. In some cases, relying to past experience can be helpful, but in other cases, this can lead to errors and wrong judgement by overestimating the likelihood of the decision.

As an investor prone to representativeness heuristic, you may be too quick to detect patterns in data that are in fact random or be too optimistic about past winners and too pessimistic about past losers.

Self-attribution bias refers to our tendency to take the credit for positive events of our lives but blame external factors when it comes to negative events. Self-attribution bias no doubt helps us protect our self-esteem. In the long run, however, it causes more harm than good, as we lose the opportunity to improve.

When affected by self-attribution bias investors having made a bad investment decision might attribute it to “bad luck”. On the other hand, an investment that works out and is successful will be attributed to their knowledge and intelligence, while in reality, it may actually be a case of just a “good luck.”

We are prone to believe what we want to believe. Confirmation bias is our tendency to favor information that confirms our existing beliefs or ideas and ignore the one, which challenges our existing beliefs. We tend to think that what our opinion and views are rational and logical, while in fact these are driven by our tendency to pay attention to the information that upholds our ideas.

This bias can cause investors to be selective when seeking for information and as a result to choose only information that confirms their beliefs about an investment and leave them in the dark regarding actual situation.

Sometimes, confirmation bias teams up with other behavioral biases like availability bias, which makes most recent or striking information peace play a greater role in the decision making than it actually should.