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Five Investing Biases and Heuristics to Watch For

16 May 2018
3 min read

Human behavior is even less rational than we think: the rational mind can be easily overwhelmed, causing us to make emotional decisions—or look for simpler questions to answer. Here are five common biases and heuristics—mental shortcuts—to be on the lookout for.

  1. Loss Aversion Colors Investors’ Worlds

    Humans tend to experience the pain of losses more acutely than they feel the pleasure of gains. In fact, the “loss aversion” heuristic reveals that investors’ motivation to avoid pain is almost three times as powerful as their pursuit of pleasure.

    That makes it easy to understand why investors are often jarred by watching or reading the news. The stories are never all positive; journalists always find something to warn investors about. Clients’ emotions get activated when a message includes anything negative. This makes investment professionals’ jobs that much more difficult.

  2. Anchoring: A Shield from Pain

    Another heuristic is anchoring. Anchoring is the normal tendency to vividly recall negative experiences. A traumatic or painful experience, like an investment loss, registers deeply in people’s brains—it helps us learn from the past and protect ourselves in the future.

    Here’s the challenge this behavior creates: Once we’ve had a painful experience, we tend to see the possibility of that experience everywhere we look. Humans create an anchor to that painful experience, and they feel that the negative event is much more likely to happen again.

  3. Availability Bias Produces Faster—Not Necessarily Better—Decisions

    Availability bias is the brain’s likelihood to focus on the choices that come first to mind, instead of sorting through all the available options. Daniel Kahneman, a leader in the field of behavioral science, calls this “the retrievability of instances” in his 2011 book, Thinking, Fast and Slow.

    For investors, availability bias can be viewed as the tendency to focus on a stock or specific investment style that has recently received a lot of press. How many of your clients are asking about investing in emerging markets or buying shares in Amazon today?

  4. Safety In Validation: Social Proof

    What is social proof? It’s when humans look at what others do to confirm that their own decision is valid. This is sometimes known as herd behavior. Do you look at what other advisors do to confirm your own decisions? Warren Buffett once said about being a successful investor: “Be greedy when others are fearful. And be fearful when others are greedy.”

  5. Safety In Validation: Confirmation Bias

    The search for alternative paths, and questioning familiar choices, is a painful and time-consuming process. Instead, our subconscious minds activate a confirmation bias—looking for validation that the previous decision was right. This might even involve ignoring evidence that there was a better option.

    This heuristic protects the decision-maker from that pain and effort. As Kahneman said, “Contrary to the rules of philosophers of science, who advise testing hypotheses by trying to refute them, people (and scientists, quite often) seek data that are likely to be compatible with the beliefs they currently hold.”

    Learning more about heuristics—and how they work—helps us recognize when they become activated in our clients and ourselves. Fortunately, it’s possible to recognize many of the common decision-making vulnerabilities that advisors are prone to. Understanding these vulnerabilities allows you to take action by helping clients see how their behavior may be causing them to make poor decisions.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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