Saturday, February 10, 2007

Managing Behavioral Biases

Biases rather Preferences

Biases can lead to failed investment strategies and should be controlled and not accommodated.
Below are several damaging biases,

Overconfidence- investors often take on more risk than they should. This can be seen from over trading. Brad Barber and Terrance Odean show in studies that there is an inverse relationship between portfolio performance and portfolio trading. In one [2000] study they reviewed 78,000 investors with a large broker firm and it showed that the annual return for the group that traded the most was about [net of fees 6% less] than the group that traded the least. Those investors who trade the most with the worst performance tend to appear overconfident of their investment skills.

Hindsight bias- people believe that they had predicted an event when in fact they did not. Most people are deceived when they exaggerate their earlier estimate of the probability an event would occur. This bias explains why events in the past seem so obvious in hindsight.

Overreaction- people are influenced by random occurrences [Kahneman and Riepe] 1998 "the human mind is a pattern seeking device". Investors overinterpret patterns that are coincidental and unlikely to persist. They react to history and their own experiences without paying attention to events that were not directly experienced or retained in memory. When we see investors squander their wealth buying high and selling low, overreaction is the cause.

Belief Persistence- people are unlikely to change their opinions even when new information becomes available. [Lord, Ross, and Lepper]1979. This can cause investors to stick with what is not working....for too long.

People are reluctant to search for evidence that contradicts their beliefs. Even if they find contracdiction evidence, they treat is with excessive skepticism. [Barbier and Thaler 2002]

Regret Avoidance - the tendency to avoid action that could create discomfort over prior decisions. This explains why investors keep their losers too long and sell their winners too early.
One reason investors refuse to sell their losers is because it admits a bad decision. To aviod the stress of admitting to the mistake, the investor holds the positon and hopes for a recovery.
Investors would achieve a higher return if they sold winners and losers with equal frequency, and even more if they sold their losers faster, and held their winners longer.

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