Just how biased are you?

I’m sure we’d all like to think we are balanced and rational investors. In reality, though, as in every walk of life, we are susceptible to behavioural biases that can, at times, influence our decision-making.

But what are these biases and how can we adjust our behaviour to help us become better investors? And which fund managers use behaviour finance as part of their investment process?

With the help of Legal & General Investment Management, we took a closer look.

Eight behavioural biases you may not know you have

1. Anchoring bias

Anchoring bias is when we rely too heavily on the first piece of information offered when making our decisions – we fixate on that piece of information to the detriment of others. We are basing our judgement on a familiar reference point that may no longer be relevant. For example, we may have avoided an asset class in the past because at the time the information was that it was a bad investment. That may not be the case today.

2. Availability bias

Availability bias is when information that is widely available to us has more influence on our decisions, whether it is relevant (or correct) or not. If the prevailing tone in the media or debate is fearful, then that may influence investment decisions and we may be more cautious. For example, investors can tend to invest in funds that have a higher profile, whereas perhaps a lesser-known fund may be appropriate forthem.

3. Herding

Herding, or following the crowd, is when we do something or invest in something because everyone else is doing so. It plays on our instincts that there is ‘safety in numbers’. However, what is a good and relevant investment for one person, may not be good or relevant for another. We need to focus on our own goals and attitude to risk, to make sure we invest in things that are right for us.

4. Confirmation bias

Confirmation bias is when we form an opinion first and research it, or find ways to justify it, second. As a result, useful new information that doesn’t agree with our view will be discounted. For example, if we hear a ‘hot tip’ from a friend, or even just like the marketing of a particular fund – and we make up our minds straight away that it is a good investment. Later, when we ‘research’, we then filter information selectively to back up our opinion.

5. Prospect Theory

This is the situation when you fear losses more than you value gains. Would you rather win £10m and then lose £9m or win £1m and keep it? There is no difference in the amount of money you have at the end of the day, 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.

6. Recency bias

We’re a bit like goldfish, with short memories that emphasise whatever has just happened. So recent events have the potential to unduly influence us. In an investment context, there is a correlation between the ownership of equities and their recent performance, because people believe recent events will continue.

Did you reach the bottom of this list and think you are relatively immune to these factors? Do you think they affect other investors more than you? If so you may be exhibiting number 7: egocentric bias; the idea that you are an exception to the rule!

Three funds that use behavioural finance to limit the impact of these biases

1. M&G Episode Income

The term ‘episode’ in this multi-asset fund name refers to those periods of time when investors’ emotions cause them to act irrationally. The investment process has been designed to prevent the manager falling victim to behavioural biases, and the cornerstone of the process is to establish which income-generating assets currently appear attractively or unattractively priced and, crucially, why. The objectivity and discipline of this analysis assists the manager to avoid falling victim to the very emotional biases he looks to exploit.

2. Jupiter UK Special Situations

The manager of this UK equity fund firmly believes that by understanding the role that emotions play in managing money, such as overconfidence and anchoring, and that by reducing those emotions, he can gain an edge to avoid many of the pitfalls that befall active managers. For example, he believes CEOs have a tendency to emphasise the positive and downplay the negative and, in turn, fund managers tend to believe what they say to reinforce their own views on the company. He therefore limits his meetings with companies to occasions when a there is a change of CEO. He finds that the new CEO typically gives more balanced information on the business.

3. Investec UK Special Situations

The manager and team behind this UK equity fund aim to understand why conventional wisdom might be wrong. One of the drivers of the team’s contrarian, value approach to stock selection and portfolio construction is sentiment: they aim to be sceptical of the crowd and aware of investor psychology, which often leads to an overvaluation of those stocks that are deemed to have good prospects and an undervaluation of those that are out of favour.