Prior to the advent of behavioural finance, it was generally assumed that people – investors included – made decisions based on rationality and logic, formally known as “expected utility theory.” However, this theory does not consider the emotional dimension within the human race. In the late 1970s, Daniel Kahneman and Amos Tversky developed Prospect Theory, which found that investors often evaluate gains and losses differently, leading to a lack of rational investment behaviour. Cognitive bias emerges as a result of investors’ inability to remain emotionally disconnected from investment decisions.
Kahneman developed a loss aversion principle known as the “‘endowment effect.” Using two groups of people, the first group was given coffee mugs and the second was given money. To sell their coffee mugs, the first group demanded $7 per mug, but the second group was only willing to pay $3. This illustrated that people generally require more to give up an object than they would to purchase it. Kahneman asserted that financial advisors often see their clients exhibiting the endowment effect, and concluded that “people don’t like giving up things,” such as stocks in a portfolio.
The “anchoring effect” is one of the principal forms of cognitive bias. It explains how investors’ lack of perfect knowledge and experience causes them to mentally anchor themselves to the relatively few events they have experienced and base their decisions, imperfectly, on those events. For example, if you buy a stock and then its price rises, you become anchored to that stock because its profitable outcome becomes a memorable event for you. Conversely, you will not become anchored to a stock that loses value. Therefore, you will ignore that stock in the future, even if it was simply bought and sold at the wrong time. Anchoring yourself to a winner, however, will cause you to keep buying the stock. Even if the stock begins to lose value, you will remain anchored to it due to your positive experience of its past performance, until it becomes too painful to hold – at which point you may decide never to buy it again.
There is also the problem of “herd bias,” whereby investors have a tendency to “go with the crowd.” Rather than making a rational, analytical investment decision, the investor’s thought process can instead be summed up as “if everyone else is buying/selling this stock, then I don’t want to miss out.” Even if the stock’s fundamentals suggest making a decision that is in conflict with the masses, the tendency to conform to the herd will lead to suboptimal investment returns.
“Confirmation bias” is another form of cognitive bias, and is applied to investors who tend to use only information that confirms their existing view regarding a potential investment. If they think a stock is going to rise, they will only seek out information that supports this view. The desire for affirmation, by seeking out sources that tell investors they are “right,” leads to skewed investment decisions.