SUMMARY

• Investors are humans and not the homo economicus
• Investing is influenced by a wide variety of behavioural biases
• Factors can be explained by a single or multiple biases

INTRODUCTION

When reading research on factors there are typically several explanation for the existence of factors. Some of the reasons are mathematical or statistical while others are more directly related to human characteristics. Some of these behavioural biases, which are often considered irrational for the homo economicus, have been described as early as 1759 by the economist Adam Smith. In this short paper we’re going to outline some of the biases that meaningfully influence investing behaviour and then describe which factors can be explained or influenced by them.

BEHAVIORIAL BIASES

We have listed 12 (the Dirty Dozen) that have a significant influence on investing behaviour. Empirical evidence shows that retail as well as institutional investors are affected by these biases.

1. Survivorship Bias

• Description: Focusing on the surviving entities of a data set
• Example: Value investing works, just look at Warren Buffett

2. Hindsight Bias

• Description: An investor believes that an event was predictable while in reality it wouldn’t have been very likely to derive that conclusion before the event
• Example: It was clear in 2000 that Apple was going to be a winner

3. Loss aversion

• Description: People tend to suffer more from losses than from equivalent gains
• Example: Investors prefer not to lose $5 than to gain $5

4. Anchoring

• Description: Focusing on historic information and not adapting to a changing market
• Example: US GDP growth is normal at 3%

5. Mental Accounting

• Description: Separating money into different mental accounts based on subjective criteria
• Example: Going for lunch to Subway to save money, but buying Fiji water as a drink

6. Confirmation Bias

• Description: Looking for information that confirms an investor’s theory vs contradicting it
• Example: My price target for one stock in my portfolio is achieved, therefore my system works

7. Herding

• Description: Following everyone else
• Example: Buying tech stocks in 1999