Imagine that you decide to go to see a new movie.  You hand the cashier at the counter a twenty-dollar bill. She gives you back a ten-dollar bill and a ten-dollar ticket. But when you get to the theater door, you realize you don't know where your ticket is. It's just lost. Do you think you'd pay ten dollars for a new ticket, or would you just head home? If you're like most people, you might be tempted to head home. In fact, when the psychologists Kahneman and Tversky presented this problem to college students, fifty-four percent of people said they'd probably just head back home. 

But now imagine a different scenario. This time, you hand the cashier at the counter twenty dollars. This time, she gives you back two ten dollar bills, so that you can easily pay ten dollars at the door to get in. But when you get to the door, you realize that you can only find one of the ten dollar bills. The other one's not in your purse or your pocket. It's just lost. Would you pay ten dollars for the movie or just head home? if you're like most people, you'd probably still go see the movie. In fact, when Kahneman and Tversky presented this problem to college students, eighty-eight percent of people said they'd probably go to the movie anyway. 

The different responses to these cases illustrate a bias known as "mental accounting."  Mental accounting bias is an information-processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.  Mental accounts are based on such arbitrary classifications as the source of the money (salary, bonus, inheritance, gambling or business profit) or the planned use of the money (leisure, necessities).  

The fact that our intuition tells us to keep things separate violates a classic economic principle: the idea that money should be fungible. Classical economists are often puzzled by the fact that we can't just think of money as money. Why shouldn't a ten dollar ticket and a ten dollar bill be the same thing inside that theater? To an economist, it should be. But for our minds, not so much. 

A negative consequence of mental accounting in making investing decisions includes: Investors irrationally distinguish between returns derived from income and those derived from capital appreciation.  People often feel the need to preserve (principal), and they focus on the idea of spending income that the principal generates.  As a result, they may choose a high-yield or "junk" bond that pays a high interest but can suffer a significant loss of principal if the company issuing the bond experiences financial difficulties.  

Another consequence is that investors may neglect opportunities to reduce risk by combining assets with low correlations. 

An effective way to detect and overcome the mental accounting behavior that causes investors to place money in discrete investment “buckets” is to recognize the drawbacks of engaging in this behavior.  The primary drawback is that correlations between investments are not taken into account when creating an overall portfolio.  Investors should go through the exercise of combining all of their assets onto one spreadsheet or another summary document to see the true asset allocation of various mental account holdings.  

With regards to the income versus total return issue, an effective way to manage the tendency of some investors to treat investment income and capital appreciation differently is to focus on the total return that includes income and capital appreciation.  Investors should learn the benefits of integrating the two sources of returns, allocating sufficient assets to lower income investments to allow the principal to continue to outpace inflation.

Much of traditional economic and financial theory is based on the assumptions that individuals act rationally and consider all available information in the decision-making process and that markets are efficient.  Behavioral finance challenges these assumptions and explores how individuals and markets actually behave.  

In my last blog post, I discussed how to overcome the six emotional biases.  Cognitive errors stem from basic statistical, information-processing, or memory errors; cognitive errors may be considered the result of faulty reasoning.  Emotional biases stem from impulse or intuition; emotional biases may be considered to result from reasoning influenced by feelings.  Behavioral biases, regardless of their source, may cause decisions to deviate from the assumed rational decisions of traditional finance.

Cognitive errors are more easily corrected than emotional biases.  Cognitive errors stem from faulty reasoning, therefore better information, education and advice can often correct for them.  Most cognitive biases can be “moderated” - to moderate the impact of bias is to recognize it and attempt to reduce or even eliminate it within the individual.

Emotions are related to feelings, perceptions, or beliefs about elements, objects, or relations between them and can be a function of reality or the imagination.  In the world of investing, emotions can cause investors to make suboptimal decisions.

These are the other key cognitive biases we should be aware of:

1. Framing bias (or Reference bias) is an information-processing bias in which a person answers a question differently based on the way in which it is asked (framed). For example, an investor is more likely to choose the portfolio that shows the highest 10-year average return (all three portfolios have positive returns) if this information is presented in the first column while the same portfolio would not be selected if the 95% probability return range (the measure of risk, and there are some negative returns) is shown in the first column.  
   
   Investors may misidentify their risk tolerances because of how questions about risk tolerance were framed; may become more risk-averse when presented with a gain frame of reference and more risk-seeking when presented with a loss frame of reference.  This may result in suboptimal portfolios.
   
   Framing bias is detected by asking such questions as, “Is the decision the result of focusing on a net gain or net loss position?”  When making decisions, investors should try to eliminate any reference to gains or losses already incurred; instead, they should focus on the future prospects of investment.
    
2. Confirmation bias is a belief perseverance bias in which people tend to look for and notice what confirms their beliefs and to ignore or undervalue what contradicts their beliefs.  A client conducts some research and insists on adding a particular investment to his portfolio.  Unfortunately, the client may have failed to consider how the investment fits in his portfolio, as well as evidence of its fundamental value.  This type of client may insist on continuing to hold the investment, even when the advisor recommends otherwise because the client’s follow-up research seeks only information that confirms his belief that the investment is still a good value.  
   
   A consequence of confirmation bias is considering only the positive information about an existing investment and ignoring any negative information about the investment.  As a result, investors may have suboptimal portfolios, leading to excessive exposure to risk. 
   
   The effect of confirmation bias may be corrected or reduced by actively seeking out information that challenges your beliefs, as well as positive information, providing more complete information to help you make a decision.  Another useful step is to get corroborating support for an investment decision. 
    
3. Illusion of control bias is a bias in which people tend to believe that they can control or influence outcomes when, in fact, they cannot.  Langer (1983) observed that people who were permitted to select their own numbers in a hypothetical lottery game were willing to pay a higher price per ticket than subjects gambling on randomly assigned numbers.  
   
   One consequence of illusion of control bias is trading more than is prudent.  Traders, especially online traders, believe that they have “control” over the outcomes of their investments.  This view leads to excessive trading, which may lead to lower realized returns than a strategy where securities are held longer and traded less frequently.
   
   Another consequence is leading investors to inadequately diversify portfolios.  Some investors prefer to invest in companies that they may feel they have some control over, like the companies they work for, leading them to hold concentrated positions. 
   
   The first and most basic idea is that investors need to recognize that successful investing is a probabilistic activity.  Be aware that global capitalism is highly complex, and even the most powerful investors have little control over the outcomes of the investments they make.  Second, it is advisable to seek contrary viewpoints.  Ask yourself: Why am I making this investment?  Is this investment part of an overall plan?  What are the downside risks?  Finally, it is critical to keep records of your transactions, including reminders outlining the rationale behind each trade.  
   
   Rationally, we know that returns on long-term investments are not impacted by the short-term beliefs, emotions, and impulses that often surround financial transactions.  Success, or the lack of success, is usually a result of such uncontrollable factors such as general economic conditions or company performance.  During periods of market turmoil, it can be difficult to keep this fact in mind. One of the best ways to prevent your biases from affecting your decisions is to keep the rational side of your brain as engaged as possible.  Creating investment research processes and building good habits are also helpful in reducing the negative impacts of these biases.  Investing success is ultimately achieved by those who can conquer the daily psychological challenges and maintain a long-term perspective.

Source: Michael M. Pompian, CFA, Sunpointe Investments. 2019 CFA Level III Portfolio Management