Being overly afraid of risk, refusing to change minds despite evidence to the contrary and holding an inflated perception of investment skill are some of the negative behaviours that can arise when investors fall victim to behavioural biases. 
John Roe, head of multi-asset funds of Legal & General Investment Management, believes that investors need to adopt disciplined independent thinking when building their portfolios because an ill-defined process can leave them at risk of suffering from a number of behavioural biases.
“Like everyone else, investors are susceptible to biases that can influence – and unfortunately undermine – their investment decisions,” he said. “But recognising this and making adjustments to your behaviour can help make you a better investor.”
In the following article, he looks at 10 of these biases and how they can lead to investors making bad decisions when running their portfolio.
For those that get to the bottom of the list and think they’re immune to all 10, Roe offers an 11th bias to be mindful of: “You may be exhibiting egocentric bias – the idea that you’re an exception to the rule.”
Myopic risk aversion
The first investment bias that Roe highlighted is ‘myopic risk aversion’, or a situation whereby investors are overly preoccupied by the negative effects of losses compared with an equivalent amount of gains.
“We tend to see the risks we take in isolation, rather than as a series of calls that, collectively, may offer favourable odds over the longer term,” he explained.
“As a result, we are tempted to take too little risk. In investment terms, the more frequently you look at your portfolio, the more you may focus on the risks – and in turn, the less likely you are to take them.”
Prospect theory
This next risk concerns the way investors value losses and gains differently. The general concept is that given a choice of one option presented in terms of potential gains and the other in terms of possible losses, people will tend to choose the former.
One way of thinking about prospect theory is to consider the choice of winning £10m and then losing £9m or just winning £1m and keeping it.
“Objectively there’s little difference, but the amount with which investors start out or gain has much more bearing on their behaviour and decisions. The joy of winning the extra £9m is overshadowed by the pain of then losing it,” Roe said.
“In investment psychology, potential gains and losses are evaluated relative to current capital, and then gains are perceived as being worth less than losses – even those of the same magnitude.”
Framing bias
With framing bias, the theory argues that people are influenced by the way in which options are presented to them when making decisions.
Everyday examples of different types of framing bias include describing beef as 95 per cent lean rather than 5 per cent fat (attribute framing) or motivating people by offering a £5 reward over a £5 penalty (goal framing).
Roe added: “An option presented as the middle choice among a group of three is most likely to be picked, as is a light colour over a dark one and a star over a triangle. The context in which options are framed fools us all.
“So, when someone extolls a number of ‘excellent investment opportunities’, they may in fact be driving you towards one in particular.”
Anchoring bias
Anchoring bias holds that people have a tendency for an individual to rely too heavily on an initial piece of information offered when making decisions.
“In making decisions, people anchor to previous information they have received and then adjust from that point, as it makes getting to a decision easier than starting from scratch,” Roe explained.
He gave the example of presenting an investor with a low percentage – say 10 per cent – and then asking them for an answer to a completely unrelated question. Even if the correct answer is as high as 100 per cent, the investor is likely to provide a much lower answer.
“They have anchored to the first, unrelated, value you provided,” he said. “Likewise, if you get a bus with a high or low number on it, you may be excessively positive or negative all day and make erroneous investment decisions accordingly.”
Availability bias
This bias concerns the tendency to judge an event by the ease with which examples of the event can be retrieved from memory or constructed anew.
Essentially, availability bias recognises that people take a mental shortcut to rely on immediate examples that spring to mind when evaluating a specific topic or concept.
“Issues that are widely discussed and information that is more easily available – in other words, material that has more profile, notwithstanding its relevance – will have more influence on decisions,” Roe explained.
“This particularly applies to stories in the news or recent internal discussions. If the prevailing tone in the media or debate is fearful, then that may influence investment decisions.”
Base rate neglect
If you ask a room of investors how good they are at investing, the majority will probably say they are better than average, even though only half of them can really be above average. This is base rate neglect.
“In the real world, it means there is a discrepancy between an event – say, a fund manager outperforming – and how likely people assess said event. However, there is usually plenty of quantitative information that can help inform our judgement,” the head of multi-asset funds added.
“Instead of going with a subjective guess of something occurring, it makes more sense to consider the ‘base rate’ likelihood for similar historic events and then adjust for why the current situation is different.”
Endowment effect
The endowment effect notes that if you give someone a gift and ask them to value it, they will generally put a higher price on it than someone who does not own it.
“It is one of the reasons people tend not to sell their poorly-performing investments and begin afresh when evidence suggests it would be prudent to do so,” Roe said.
“It also means that fund managers are often retained by investors far longer than they objectively should be.”
Status quo bias
When status quo bias is present, an investor is displaying an emotional preference of the current situation. This can lead them to make irrational decisions, such as remaining in a sub-optimal situation when there are better alternatives.
“Usually, making a new decision seems more painful than doing nothing. From their starting position, investors view anything they lose by selling as a loss and any gains, naturally, as a gain,” LGIM’s Roe said.
“But because they tend to attach more significance to losses than to gains, the status quo bias is another factor that stops investors from selling.”
Confirmation bias
Confirmation bias is similar to ‘wishful thinking’ and highlights people’s tendency to ignore information that goes against a concept or idea that they already believe to be true.
When suffering from this bias, investors could stop gathering new information once they have enough evidence that their current view is correct or they could continue to seek out information that supports their view while ignoring or rejecting anything else.
“Once people make a decision, they don’t like changing it. We tend to believe we are right and are overconfident in our choices,” Roe explained.
“As a result, useful new information that doesn’t agree with our view will be discounted, while less useful information may be used to justify it. Investors guilty of this may fail to process new information and can miss important new angles.”
Recency bias
When suffering from recency bias, investors believe that more recent information is more important and valuable than old information.
Examples could include investors being afraid to take risk in the years after the financial crisis as they expected markets to sell off again or, more recently, expecting stock markets to continue making strong gains with low volatility.
“We’re like goldfish, with short memories that emphasise whatever has just happened. So, recent events unduly influence us,” Roe concluded.
“In an investment context, people tend to sell after markets fall and buy after markets rise. There is a correlation between the ownership of equities and their recent performance, because people think recent events will continue. But buying at or near the top of the market and selling at or near the bottom? Not a formula for success.”