Behavioral Biases in Asset Allocation

Loss aversion is a bias in which investors dislike losses more than they like gains. This makes it difficult for investors to maintain discipline when returns are negative.

Illusion of control is a tendency to overestimate the ability to control events. Combined with overconfidence, it typically leads to investors failing to diversify, trading too frequently, or both. Some common signs of this bias include:

  • Frequent trading and tactical allocation shifts in an attempt at market timing. Investors who correctly call the reversal of a trend have too much confidence in their ability to repeat.
  • Active security selection by institutional investors who believe the level of resources at their disposal gives them superior asset selection skills.
  • Above average use of short selling and leverage.
  • Shifting asset allocations despite a lack of consensus opinion as an individual trustee believes they know better than the market.
  • Concentrated positions that expose the portfolio to diversifiable risk.
  • Use of biased risk and return forecasts in the asset allocation framework that result in allocations that are inappropriately different from the market portfolio.

Mental accounting involves separating assets and liabilities into different “buckets” based on subjective criteria.

Representative bias, or recency bias, occurs when investors attach more importance to recent data than old data. The most common result is for an investor to shift allocations towards assets that have performed well recently.

Framing bias occurs when the way information is presented affects the resulting decision. This is a common problem in asset allocation. If risk is presented as standard deviation, most investors prefer the lower risk. But downside risk measures may be more useful in specific situations. These include:

  • VaR indicates amount of loss at some probability over a time.
  • Conditional VaR quantifies the average loss within the VaR tail.
  • Shortfall probability directly states the probability of some adverse outcome occurring.

Availability bias occurs when personally experienced or more easily recalled events disproportionately influence decisions.

Familiarity bias may be considered an offshoot of availability in that what is familiar or easy to recall is given too much importance in the decision process.

Home bias can be considered another offshoot and is often seen in portfolios that over allocate to domestic securities, missing the opportunity to diversify with international securities.

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