Common Behavioural Biases

5.2 Common Behavioural Biases

Behavioral biases—sometimes called “cognitive traps”—are those pesky, deeply ingrained thought patterns that often nudge us to deviate from rational decision-making. They might make us cling to outdated information, fixate on recent trends, or follow the crowd before examining the facts. In the context of mutual fund investing (or really any investment strategy), being aware of these biases is crucial. If left unchecked, they can undermine prudent decision-making, distort our perception of risk, and lead to underperformance, missed opportunities, or unwarranted remorse.

I remember the first time I realized I’d been swayed by a bias: I’d invested in a fund purely because all my colleagues were talking about it during lunch. It was the single biggest water-cooler hype I had ever seen, and I fell for it. Let’s just say that months later, the fund’s underperformance reminded me why blindly following the herd isn’t exactly a winning strategy.

Before we dive in, here’s a quick visual to help you see the path from bias to (potentially flawed) investment decisions:

    flowchart LR
	    A["Behavioral Biases"] --> B["Emotional Triggers <br/> (e.g., fear, excitement)"]
	    B --> C["Investment Decisions"]
	    C --> D["Potential Portfolio Outcomes"]
	    D --> E["Refine Approach <br/> or Miss Opportunity"]

As you can see, biases kickstart emotional triggers, which then spur decisions. Ultimately, these decisions shape the fortunes of your portfolio. Let’s explore the most common biases relevant to mutual fund investing, along with tips, real-life examples, and references to Canadian regulations and resources.

Confirmation Bias

Confirmation bias is all about selectively seeking (and remembering) data that aligns with your preconceived views. It’s like when you google “Why my favorite mutual fund is awesome,” conveniently ignoring all the articles warning about the challenges that fund might be facing.

• Example: Suppose a client firmly believes that high-tech mutual funds are unstoppable. They hear about economic risks, interest-rate hikes, or new regulations that could hurt tech valuations—but dismiss these points as “irrelevant.” Unfortunately, a downward market shift might catch them off guard because they’ve been shielding themselves from any perspective that runs counter to their optimism.

• Mitigating the Bias:

1. Encourage open conversations that invite both positive and negative views of any investment.
2. Use standard checklists or structured portfolio review templates that force looking at pros and cons.
3. Access multiple data sources—analyst reports, commentary from contrarian experts, economic forecasts.

• Regulatory Context:

• Under Canadian Securities Administrators (CSA) National Instrument (NI) 31-103, advisors have a responsibility to fully understand client needs and make suitable recommendations. A balanced perspective helps ensure decisions aren’t clouded by one-sided information.
• CIRO (Canadian Investment Regulatory Organization), Canada’s self-regulatory organization for investment and mutual fund dealers, expects its registrants to maintain high standards of due diligence. By actively challenging your assumptions, you’ll be in a better position to meet CIRO guidelines for fair dealing.

Anchoring Bias

Anchoring bias happens when we lock onto the first piece of information we get—often a fund’s original purchase price or a target return someone mentioned. While anchors can be useful reference points, they can also become irrational stumbling blocks. For instance, imagine you purchased a mutual fund at $20/unit. If the price fell to $15, you might keep hoping it’ll bounce back to $20 (the “anchor”), even when the market indicates the fund may not recover to that level.

• Example: A client says, “I can’t sell below my original cost—no way.” Meanwhile, the fund’s fundamentals have changed drastically. That unwavering focus on the initial cost can lead to holding a losing position for far too long, or forsaking a better investment opportunity.

• Mitigating the Bias:

1. Reassess the rationale for staying invested based on current fundamentals, not past prices.
2. Conduct regular portfolio reviews anchored to forward-looking assessments (e.g., expected returns, economic indicators).
3. Remind yourself (and your clients) that markets are dynamic, so the “old” anchor might be pretty meaningless today.

Recency Bias

Recency bias is the tendency to weigh recent events more heavily than older facts. “Hey, that mutual fund soared last quarter—so it must keep soaring!” But short-term spikes don’t automatically forecast a stable long-term trend.

• Example: An equity mutual fund has a phenomenal three-month run. A client thinks, “It’s hot right now, so it’s bound to keep winning!” Without a deeper look at investment strategy, sector trends, or global economic shifts, they could over-invest in the fund. Then, if the market corrects, they could face an unexpected loss.

• Mitigating the Bias:

1. Look at historical data spanning multiple years and market cycles.
2. Compare performance to relevant benchmarks or peer groups over consistent institutional time frames (e.g., three-year or five-year rolling returns).
3. Follow a formal rebalancing strategy—some advisors set triggers (e.g., each quarter) to rebalance, pulling back from “hot” funds that overshoot their target allocation.

• Touchpoint with Regulation:

• NI 31-103 emphasizes “know your client” (KYC) and “suitability” requirements that must be met continuously. If you only consider recent performance, you might end up recommending something that doesn’t fit a client’s overall risk profile or long-term objectives.

Overconfidence Bias

Overconfidence bias is when investors or advisors overestimate their own abilities—maybe thinking they can outsmart the market with a few quick trades or by picking “can’t miss” funds. I’ve certainly been there: telling myself, “I know exactly when the market will peak.” Usually, I don’t.

• Example: A new advisor might be so confident in their stock-picking skills that they actively churn the client’s portfolio, inadvertently increasing costs and taxes, without actually improving returns.

• Mitigating the Bias:

1. Embrace humility. Maintain an investment policy statement (IPS) that outlines your strategy, risk limits, and asset allocation.
2. Seek second opinions or market analyses from other professionals.
3. Compare performance to suitable benchmarks—if you’re not beating them consistently, overconfidence might be at play.

Herding Bias

Herding bias is basically the fear of missing out (FOMO) on a grand scale. Investors jump onto a trend because “everyone else is doing it.” When large groups chase the same funds, they can inflate bubbles that eventually burst.

• Example: Think of the dot-com bubble of the late 1990s or the cannabis-stock frenzy not too long ago. Soon enough, too many people piled on with minimal research. When the hype fizzled, many saw sharp losses.

• Mitigating the Bias:

1. Focus on fundamentals rather than “hot” headlines or social media chatter.
2. Diversify across sectors, asset classes, and geographies.
3. Keep a watchful eye for “groupthink” influences in your office or your online communities—healthy skepticism can protect you.

Disposition Effect

The disposition effect describes the tendency to sell winning investments too early (to “lock in gains”) and hold losing investments for too long, hoping they’ll bounce back. The emotional drag of accepting a real loss can be intensely uncomfortable.

• Example: Let’s say your client invests in a sector-specific mutual fund that’s soared above its purchase price. Even though the sector fundamentals suggest future growth, they might want to sell quickly out of fear it could drop at any moment. Meanwhile, they keep a struggling fund because they can’t bear to disclose a loss.

• Mitigating the Bias:

1. Use preset sell targets or rebalancing thresholds that remove the emotional element.
2. Remind clients that a loss isn’t a reflection of personal failure—market volatility is part of investing.
3. Evaluate all holdings with the same yardstick: if you wouldn’t buy the losing fund today at the same price, it might be time to look for better options.

Status Quo Bias

Status quo bias is the impulse to do nothing simply because that’s what you’ve always done. Whether it’s continuing with an expensive fund, ignoring a new tax-efficient structure, or missing fresh opportunities—people like to stick with what’s familiar.

• Example: A client who inherited a portfolio 15 years ago might not want to make changes, even if half the funds are outdated or underperforming. It feels safer to just leave it as is.

• Mitigating the Bias:

1. Commit to periodic reviews—annually, semi-annually, or triggered by notable life events (e.g., retirement, marriage, or new business opportunities).
2. Provide data on how adjusting or rebalancing the portfolio could enhance returns or reduce risk.
3. Encourage small changes first. For instance, reallocate just a portion of the portfolio if the client is extremely hesitant.

Regret Aversion

Regret aversion refers to the fear of making a decision that might turn out badly. Instead of actively seeking opportunities, investors sometimes freeze—preferring to avoid potential mistakes. In real life, that can mean letting your cash sit idle when you’d be better off investing.

• Example: During volatile economic times, a client might say, “I’d rather do nothing than risk regret.” Over the long term, ignoring potential growth could lead to missed wealth accumulation or the erosion of savings by inflation.

• Mitigating the Bias:

1. Break down investment decisions into smaller, more comfortable steps.
2. Create hypothetical scenarios or stress tests that illustrate the potential consequences of inaction.
3. Share success stories or case studies showing how taking modest, well-calculated risks can pay off.

Recognizing Biases in Yourself and Your Clients

It’s all well and good to spot biases in your clients, right? But we, as advisors, are equally prone to them. Maybe we’re anchoring on a specific prospect’s question, or feeling overconfident about our recommended allocations. Recognizing biases in ourselves requires regular introspection. This might mean:
• Participating in peer reviews or mentorship programs.
• Documenting your rationale for certain recommendations and reviewing them in hindsight.
• Encouraging a “devil’s advocate” argument within your team.

In Canada, the expectation to “know your client” doesn’t just refer to gathering client data; it also implies a deeper understanding of behavioral tendencies and how they might interfere with wise investment decisions. After all, the best mutual fund product still needs a person with a clear mindset to stick with it.

Structured Approaches to Mitigate Bias

Sometimes, I think structure is the best antidote to bias. For instance, adopting a formal Investment Policy Statement (IPS) clarifies an investor’s goals, risk tolerance, and constraints. When market euphoria or panic hits, you have a logic-based blueprint to guide your decisions. Many advisors also adopt systematic rebalancing schedules. By automating steps—like selling some portion of a winning fund and adding to a lagging but still fundamentally strong one—clients can dodge impulsive moves driven by short-term noise.

The business cycle phases (discussed in Chapter 3: Overview of Economics) can also play into biases. If the market’s in a recovery phase and most funds are rising, recency bias might spark a false sense of permanent optimism. Overconfidence can surge. A well-defined process counters these impulses by relying on robust data and disciplined guidelines rather than fleeting passions.

Practical Examples and Real-World Scenarios

• A mid-career investor sees a mutual fund that’s posted a 25% return over the past six months. He invests heavily, anchored in that figure. But the economy soon enters a slower growth phase, and the fund stumbles. Later, the investor regrets not examining the fund’s fundamentals or correlated risk.
• A retiree, anxious about market downturns, decides to hold onto a losing balanced fund, hoping it’ll rebound. Meanwhile, opportunities in higher-quality bond funds pass by. This disposition effect leads to bigger losses as the balanced fund declines further.

References and Additional Resources

• Regulatory Framework:

• CSA National Instrument 31-103 (Registration Requirements, Exemptions, and Ongoing Registrant Obligations): https://www.osc.ca/en/securities-law/instruments-rules-policies/3/31-103
• CIRO (Canadian Investment Regulatory Organization) for guidelines on compliance, suitability, and standards of conduct: https://www.ciro.ca
• The Canadian Investor Protection Fund (CIPF) is now Canada’s sole investor protection fund, safeguarding client assets if a member firm becomes insolvent.

• Behavioral Economics & Psychology:

• The Behavioural Insights Team: https://www.bi.team/ (publications and research on applying behavioral insights).
• Bank of Canada: https://www.bankofcanada.ca/ (useful economic indicators that may trigger or amplify certain biases).
• “Misbehaving” by Richard Thaler: an excellent deep dive into the realities and quirks of human behavior in financial markets.

• Open-Source Tools:

• Tools like Python libraries pandas or NumPy (for quantitative analysis) help systematically evaluate performance data and identify if your viewpoint is short-term or anchored.
• R’s “quantmod” package can be used to chart funds over long horizons, smoothing out recency effects and bridging the gap between “feeling” and “knowing.”

Best Practices and Common Pitfalls

Best Practices
• Stick to a consistent decision-making framework.
• Encourage your clients (and yourself) to explore a range of viewpoints, not just the ones that sound comfortable.
• Keep robust records of each transaction: the rationale for the purchase, the target holding period, and conditions for selling.

Common Pitfalls
• Allowing an anchored price or recency-based burst of enthusiasm to override fundamentals.
• Letting unchallenged biases ossify into a long-term habit that resists reevaluation.
• Ignoring the role of emotions or dismissing them as irrational. Emotions can be rational if channeled appropriately (for instance, caution is valuable, but not if it morphs into total inaction).

Final Thoughts

Recognizing and addressing common behavioral biases is one of the most crucial steps in guiding clients to healthier financial habits. It means establishing transparent, data-driven processes that can withstand emotional turbulence. It means we, as advisors, step back periodically to see if our judgments align with reasoned analysis rather than impulse. And it means communicating openly with our clients so that they trust us enough to break free from unhelpful patterns.

So next time you find yourself saying, “Ah, but last month was amazing!”—ask: “Am I letting recency bias rule here? Does that last month’s performance really forecast the future?” A little introspection goes a long way. The more you practice identifying biases, the more likely you’ll steer your clients toward better long-term outcomes.

Mastering Common Behavioural Biases: Your Essential Quiz