Homo economicus is the Alexa or Siri of neoclassical economists. An elegant modelling of human behaviour, which always pursues its own interest in a sensible and rational way. A robot that responds to monetary stimuli with the precision of an algorithm. The bad thing is that the human being is far from being that perfect decision making machine. Often, we make bad choices. We make decisions that hurt us. We don’t choose the easy way out. We don’t properly calibrate the risks. Nor do we properly assess all the alternatives we have. Our mind tricking us into investing time, money and energy where we shouldn’t.
A branch of knowledge known as behavioural economics has developed over the past forty years. A hybrid between psychology and economics that analyses how people act when making economic decisions, rather than theorising about how they should behave. The culmination of the rise of this branch of knowledge was the award of the Nobel Prize in Economics in 2002 to Daniel Kahneman, one of its leading theorists.
Among the great advances in behavioral economics is the precise detailing of system failures. All the traps we set for ourselves when we make decisions that affect our heritage. These are called behavioural biases and they cause us to act in an unreasonable way and to make many decisions that go against our interests. A risk that becomes very evident in times of high uncertainty like the present.
1. Overconfidence bias
People think we’re smarter than we are. We think we know how things work, when really we only have a purely superficial idea. “The overconfidence bias is one of the most pernicious biases there is. It can lead you to think that the probability of your investment failing is very low,” explains María Eugenia Cadenas Sáez, an analyst in the financial education area of the National Securities Market Commission (CNMV).
In the financial sphere, a confident person tends to underestimate the risks of his or her decisions, while overestimating the expected gains. In general it leads them to buy and sell in excess, incurring high transaction costs that reduce profitability and to have insufficiently diversified investment portfolios.
A good example of this bias is the studies that have asked about driving. 94% respond that they drive like the average or better than the average, which is obviously impossible.
This flaw is closely linked to the illusion of control bias and the excess of optimism.
2. Confirmation Bias
“See, what I was saying.” With this short phrase we could describe this trap of our mind. “Confirmation bias involves the selective gathering of evidence. We only listen to those that match our thesis,” points out Cadenas.
If a person, for example, considers that technology companies are too complex to invest in, he or she will be alert to any news or report that reinforces his or her thesis. When a technology company announces a downward revision of its income, it will say: “you see, if you can’t trust it”. What will cost him more is to be humble enough to see the spectacular revaluation that the sector has had in the last decade and to admit that perhaps he has been wrong. The world’s most famous investor, Warren Buffett (Berkshire Hathaway’s largest shareholder) did. “I’ve been an idiot for not investing in Apple before,” he came to acknowledge.
This flaw in the system is very much connected to the anchorage bias. This consists of giving more weight to the information obtained in the first place than to new information that contradicts it. Its name is due to the fact that these previous ideas sometimes involve real anchors that are difficult to drop. In the investment world, this bias is often seen, for example, when the performance of an investment product is presented first, so that other data not as positive as the associated risks are no longer considered, or the price of a share is taken as a reference for its past performance.
3. Social Test Bias
If a few acquaintances are investing in savings bank preference shares, which yield 5%, why shouldn’t I? The social test bias is the tendency to imitate the actions of others in the belief that they are adopting the right behavior.
In Spain, not only have there been massive investments in preferential shares (an opaque instrument, which ended up in the courts, and with the State having to partially compensate hundreds of thousands of people affected), there has also been a fever for investment in stamps or trees, which have ended up in absolute fiasco or which have turned out to be pure pyramid schemes. How is it possible that this type of such heterodox investment ended up capturing so much money? Mainly because of the imitation effect, because of the social proof bias.
In the La Mancha town of Pedro Muñoz, with 7,000 inhabitants, almost half the population had invested in Forum Filatélico and Afinsa stamps. If my neighbour is earning 6% a year, why shouldn’t I?
4. Authority bias
What our neighbor or brother-in-law does influences us. But also the opinions of important people. It is the tendency to overestimate the opinions of certain people simply because of who they are and without subjecting them to prior judgement.
On Monday, February 28, 2020, the well-known economist José Carlos Díez (close to the Socialist Party and whose name even sounded like a possible Minister of Economy) wrote on his Twitter account: “Don’t you know what to invest your savings in? Buy Telefónica at 5.39 euros per share”. By this time, the Covid-19 pandemic was already hitting Italy and had quietly infiltrated all over Spain.
If you consider that 10 years earlier those shares were quoted at 17 euros and that José Carlos Díaz is a professor of economics at the University of Alcalá de Henares, it might seem like good advice. However, four months later, Telefónica shares are trading almost 20% below the price Diaz recommended. Listening to famous people is not always recommended.
Another example of the problems of authority bias is when statements by Nobel Prize winners are used for any topic, even if it has nothing to do with the branch for which the award was given. There have been Nobels with overtly racist, conspiratorial or outright nonsensical statements. The discoverer of HIV, for example, Luc Montagnier, has defended the use of homeopathy, despite it being a pseudo-therapy systematically discredited by the entire scientific community.
5. The halo effect
This is the tendency to prosecute a person or institution on the basis of a single positive or negative quality that overshadows all others. It is a very common bias in the investment field, so that a financial product tends to be rated as good or bad based on a single piece of information, for example, the company’s results or the popularity of the marketer or manager of the financial product in question, without considering that this financial product may not be suitable for the intended investment objective or its own risk profile.
One of the implications of this bias is to confuse the notoriety of a brand or product with the solvency or profitability potential of the company that owns it. Thus, investors have a preference for investing in companies with brands they know, especially when they are from their own country. How can it not go well on the Banco Santander Stock Exchange, with the number of offices they have and how powerful their owners are? However, reality often shows that this notoriety does not have to be linked to profitability.
6. Hyperbolic Discounting
We love sayings. Concentrated wisdom. Infallible. Or not so much? “Better a bird in the hand than a hundred in the bush.” Well, that depends. What if I had a way to catch them? Even if it’s only 10%. The hyperbolic discount bias is the propensity to choose smaller, more immediate rewards over larger, more distant ones. This is because the immediacy of the rewards has a great power of attraction.
Hyperbolic discounting can lead the investor to undo an investment that was intended for the long term and suitable for his or her profile due to an eventually attractive evolution of the markets or the appearance of more profitable financial products, thus altering the initial objectives and entailing associated costs and risks. Analyzing probabilities, threats and rewards is not always easy. And applying the plan drawn up is even less so.
7. Sunk cost fallacy
This mind trap is especially harmful to gamblers. When they have lost a lot of money at the poker table they think the best way to get it back is to keep playing. Big mistake. This bias leads us to maintain an investment that is generating losses for fear of losing what has already been invested. In those moments it is necessary to have the cold blood to analyze if the company is going to be able to recover, without taking into account the money that has already been lost.
8. Status quo bias
Let’s face it, we’d rather do nothing than do something. It’s hard for us to choose. We’re terrified of making mistakes. In the investment world, we tend to make a choice, and forget it. Why change. The bias of the status quo implies that the current situation is taken as a reference point and any change with respect to that point is perceived as a loss. A very clear example is what happens with pension plans. Researchers have shown that most savers do not choose to change plans, even though they know that theirs is mediocre and that passing the money on to another plan will not cost anything.
9. Loss aversion bias
This bias refers to the tendency to consider losses to outweigh gains. In other words, the fear of losing something is a greater incentive than the possibility of gaining something of similar value. When it comes to investing, it is possible that, as long as you do not incur losses, you will maintain an investment with minimal prospects of recovery and you will end up losing everything you have invested. It is also very common that, when the time comes for stock market corrections, there are many investors who choose to sell, because they cannot bear to see that their balances have become negative during the year. Advisors recommend, in these situations, to remember the premises we started from when investing. If you have agreed to temporarily endure losses of up to 10% you must be consistent.
10. Blind Spot Bias
The rear-view mirrors have a certain point where the car that is going to overtake us is so close that you can’t see it anymore. This blind spot is particularly dangerous, because when we look in the mirror we see nothing and we are falsely sure that there are no cars. In behavioural science, there is talk of blind spot bias to believe that you have no bias at all. “You can also talk about metaseism, or just seeing the irrationality in someone else’s eye.