Main Forms of Investor Biases
Everyone trying to attract additional funds for their startup has likely experienced various investor prejudices. In this article, we have identified the top 6 biases you may encounter. Knowing them in advance, will enable you to prepare counterarguments and achieve better results in the long run.
Why can investors be irrational according to Behavioral Finance?
Although many believe that people are rational by nature, we all know this view to be an oversimplification of the truth. The cyclical investment process is replete with psychological traps that greatly influence one’s judgement. Learning about inherent behavioral biases and actively avoiding them helps investors make impartial decisions.
Bias are deeply held opinions or views in favor of a particular perspective that often stem from the gap between reality and heuristic solutions.
Investor bias can be the result of several heuristics and mental models. False reasoning, emotional biases, perceptual distortions, and other psychological or behavioral problems influence financial decision-making.
What prejudices might you face?
We conducted comprehensive analysis and identified the most common prejudices that a startup is likely to face:
- Frame dependency;
- Offset confirmation;
- Mental accounting and household money;
- Loss aversion;
- Conservative bias.
Frame addiction is a cognitive perseverance bias where a question is answered differently depending on its phrasing. This can lead investors to focusing on changes in wealth rather than wealth levels, forcing them to make inconsistent decisions.
Thus, structure-dependency bias is defining an investment with potential gain versus framing an investment with possible loss, although expected outcomes are the same across different probabilities. Another example of frame dependency concerns the opt-in and opt-out options. Although the result is the same, the way the scenario is constructed results in varying participant behavior patterns.
Confirmation bias is a belief persistence bias in which investors overemphasize information that supports their beliefs and ignore, avoid, or underestimate views that contradict pre-existing assumptions. This situation occurs when investors tend to agree or actively seek information and viewpoints that support their opinion, while ignoring or avoiding contradicting information.
Under-diversification or overconfidence can result from confirmation bias, since compatible information is more likely to influence such investor’s reasoning. This can lead to increased expenditure in bad investments or an unwillingness to exit losing positions.
Mental accounting is a cognitive processing distortion in which investors separate money into different mental categories depending on the source of the funds. Equal amounts of money are treated differently depending on which type the money belongs to.
For example, someone might be tempted to spend paycheck money differently from tax return money or invest conservatively for retirement but take more risks in a segregated account where they feel the loss is acceptable.
In mental accounting and household money, funds generated via income are treated differently from revenue generated through capital gains, and the source of funds can influence subsequent investment decisions.
Loss aversion is an emotional bias that comes from prospect theory. With loss aversion, investors avoid risks to the extent that they do not close the losing position and realize the loss because that would make the loss a reality with a subsequent financial impact.
It goes beyond risk-averse behavior to the point where an investor no longer acts when considering investment losses. The reluctance to sell an investment that has declined in value and accept a loss on the account outweighs a prudent decision to accept the same loss, despite any indication that this would be a pragmatic decision.
Anchoring is a behavioral information processing bias where investors tie investment value to the price they originally paid for security rather than its current value. Any follow-up information received after the purchase is weighted against that fixed price.
Anchoring is also called the break-even effect or disposition effect. The investor ties emotions to a specific price, therefore mentally tying the value of the investment to this price and ignoring changes in the market or a security paper that can affect this cost. This anchor can be the purchase price or some expected future value.
Conservative bias is a perseverance-based bias in which investors hold onto their old views despite the influx of new information. Investors overestimate their initial beliefs and ignore further details.
Conservative bias prevents investors from updating their models and/or forecasts. Instead, investors tend to rely on the initial information that guided them in their decision-making, despite the availability of new and more recent data.