Volatile markets and behavioral biases – Part II

In my last post I discussed how it is useful to be aware of one’s behavioral biases, especially during a volatile market like the one we are experiencing currently. I then went on to list some relevant emotional biases. Now it is time to discuss cognitive biases.

Anchoring and adjustment bias

This bias refers to a tendency to “anchor,” or rely too heavily, on one piece of information, and then adjust from that reference point when estimating the value of something. For instance, if you buy a stock for $100 per share and it later reaches $200 before falling down to $150, the high of $200 could serve as an anchor and have an unreasonable effect on the investor when evaluating under what circumstances the stock can be sold.

Volatile markets and behavioral biases

After years of low and declining volatility, investors have had some adjustments to make in the last six months or so. Volatile markets, especially falling ones, can play tricks on the mind. None of us are immune to the various behavioral biases that have spawned the now popular field of behavioral finance. Being aware of those biases should help, however, and I recently decided to review the literature to be better protected from my own rationality. As a guide, I used Behavioral Finance and Wealth Management by Michael M. Pompian, which I would recommend as an introduction to the field.

Out of the 20 biases Pompian discusses, I have singled out 8 which I consider most relevant at this time. In order to keep my blog posts within reasonable length, I will divide these into two sections. The biases are separated into emotional biases and cognitive biases. This post will deal with emotional biases and the next one with cognitive biases. I am not making any specific recommendations, but merely reminding you to be aware of these common pitfalls.