Bad Behavior: From A to Z … and Back Again

Talking Shop

A common reaction to pointing out to investors (or indeed, anyone) that they're as biased as a Fox reporter at a convention of transgender liberal pacifists is for them to respond, not unreasonably, by asking what they should do about it (that's the investors, not the reporters). It turns out that it's a lot easier to say what's wrong than to actually do anything about it.

The A to Z of Behavioral Bias is an attempt to address that issue, but it does rather show that there's no such thing as a common source of biases; bad behavior comes from many sources and requires many solutions. Or does it?

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Z is for Zero Risk Bias

Zero-risk bias is a preference for options that completely eliminate some risk even where alternative, often cheaper, options will reduce the overall risk by more, proportionately.We often prefer the absolute certainty of a smaller benefit to a larger benefit of less certainty.

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Y is for Yawn Effect

The Yawn Effect occurs when you yawn in response to someone else yawning. In fact you can even get your dog to do it (or get coerced into yawning by your pooch). Yawning is contagious, and contagion is an inevitable unconscious consequence of people interacting with each other – and, as usual, when we behave automatically as investors it doesn't make for a good financial outcome.

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X is for Xenophobia

OK, Xenophobia isn't really a behavioral bias, but Home Bias is its equivalent – the tendency of investors to favor their home markets over foreign ones and to damage their returns, or at least increase their risks, in the process.

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W is for Winner’s Curse

The Winner's Curse occurs when in order to win a competitive pricing situation such as an auction we overpay. By overpaying we destroy the investment case for buying in the first place and the losers turn out to be the winners. Of course, overpaying for anything is unfortunate, but competition has strange effects on our brains.

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V is for Von Restorff Effect

The Von Restorff Effect states that something that stands out is more likely to be remembered. So a highlighted item on a list is more likely to be recalled than the remainder of the list items. The effect demonstrates the unreliability of memory, which isn't any kind of photographic process but is a more complicated affair, generated on the fly from bits and pieces of information we can bring to mind.

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U is for Uncertainty

Uncertainty is the reality of the unknown unknowns. We don't know what we don't know: we can't even measure it. And we don't like it, not at all. In fact we don't like it so much we're prepared to ignore it, which is unfortunate as it's an 800 pound gorilla sitting in the corner. Painted blue, wearing a tutu and playing a bassoon.

We really hate uncertainty.

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T is for Texas Sharpshooter Effect

The Texas Sharpshooter Effect is a doozy, although it's less of a bias and more a sleight of hand trick. Impressed by that fantastic mutual fund history? Amazed by that stock tipping sheet performance? Dumbfounded by that guru's record of predicting market movements? Roll up, roll up and see the Texan Sharpshooter in action …

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S is for Self-Enhancing Transmission Bias

Self-Enhancing Transmission Bias is what everyone does when they talk about themselves: they big themselves up and conveniently forget about their mistakes. And as everyone does this across a network you will get an amplification effect: everyone is great at investing and no one ever gets stuff wrong. And the more we broadcast, the greater the effect.

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R is for Representative Heuristic

The Representative Heuristic is our trick of comparing whatever happens to be under consideration to whatever we can bring to mind. It's an effect of availability, but we can be primed into triggering the heuristic by clever manipulators or not-so-clever psychologists.

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Q is for Quantification Fallacy

The Quantification Fallacy is a logic error where the premises don't justify the conclusion. It's very common in investing lore where the tendency to omit just small amounts of qualifying information can often lead to strong conclusions being drawn from frankly dubious underlying data.

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P is for Priming

Priming is a psychological sleight of hand, a method of the brain preparing itself for what is about to happen. It's a bit like predictive text, very useful when it works but utterly awful when it goes wellythrowing (*). And, if you know what you're doing, you can prime people to get them to make the decision you prefer. Great for influencers, not so good for the influenced.

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O is for Overconfidence

Overconfidence is highly underrated as a cause of poor investing behavior. You see, almost no one believes that they, themselves, are overconfident. Generally we're very confident about the fact we're not overconfident. Generally we're wrong.

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N is for Negativity Bias

Negativity Bias is a reference to our general predisposition to regard negative events as more salient and potent than equivalent positive ones. In particular it's associated with the idea of contamination – "a spoonful of tar can ruin a barrel of honey but a spoonful of honey does nothing for a barrel of tar".

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M is for Mental Accounting

Mental Accounting is the term given for our habit of mentally allocating money to various accounts and then acting as though they're in separate high security vaults, transferable only by using a elite team of undercover operatives armed with a teleporter and a genetically modified ape. From there it's a short step to using our mental accounts to engage in some perverse and financially draining behaviors.

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L is for Loss Aversion

Loss Aversion is the name given to our aversion to losses (duh). We're twice as unhappy at a loss as we're happy at an equivalent gain, which leads us into keeping rubbish investments (to avoid realizing a loss) and into selling good ones (because then we can never take a loss). Under loss aversion selling or buying has no relationship to the actual investment merits of the asset, it's all about our emotional attachment to an arbitrary number.

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K is for Kruger-Dunning Effect

The Kruger-Dunning Effect (or, more traditionally, the Dunning-Kruger Effect) identifies the issue that some people are too stupid to know that they're stupid. They're also completely convinced that they're correct, regardless of outcomes or feedback. This is a very dangerous combination, especially in a world of digital connectivity, where whoever is most confident is the guru most followed.

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J is for January Effect

The January Effect  is the observation that small cap stocks consistently outperform markets in January. It's one of a number of calendar related anomalies that suggest there's a peculiar interaction between people, markets, tax regimes and the environment. You can take the investor out of their natural environment, but you can't take the natural environment out of the investor.

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I is for Illusion of Control

Illusion of Control refers to our convoluted efforts to retain the belief that we're in control in situations where we really aren't. In fact, having some level of autonomy seems to be important for our psychic health but there are times where we take this to extremes. Like when we think we can predict anything about stockmarkets.

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H is for Hindsight Bias

Hindsight Bias is the tricky problem that in the past we think we predicted the present, so here in the present we think we can predict the future. Only we didn't predict the present, we only think we did, and we can't predict the future because we don't have the gift of foresight. Nobody does (that only happens in movies and magic shows and it's not real).

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