Our final personal finance bias is known as status quo bias. As the name suggests, this bias causes an investor to prefer the current state of affairs. Also known as “investment inertia”, this psychological trap can allow investing mistakes to perpetuate and losses to mount. This behavior is closely aligned with loss aversion, the bias we discussed on July 6. Our preoccupation with avoiding losses and not admitting mistakes causes us to do nothing when corrective actions may clearly be warranted.

Herd instinct is the observed human behavior which causes us to join groups and follow the actions of others. Also known as bandwagon effect, it can explain why people take various actions. It has even been observed in small children who will often want to do “what everyone else is doing.” For investors, herd bias can move markets strongly to the upside, but unfortunately, also to the downside.

Escalation of commitment is a behavior that can sometimes make a bad situation even worse. This pattern of behavior involves the prospect of facing increasingly negative outcomes from a past investment decision. A rational investor would re-evaluate their original decision process and incorporate new information. This new information may possibly lead to the conclusion that the original investment was a mistake, and the rational action would be to liquidate, in order to eliminate possible future losses. However, for many people, there’s a reluctance to admit the past error of judgment and they escalate their commitment by investing even more money into the same declining security.

Our next behavioral bias can lead us to make decisions that are less than optimal, often resulting in missed opportunities both in investing and in other facets of our lives. Endowment effect causes us to place a higher value on something that we already own, even though there might be ample evidence that an identical object could be readily acquired elsewhere for a lower price. A well-known study starts with a college professor who gives a coffee mug to each student in one of his class sections but does not give such gifts to his students in a second class section. A week passes and the professor asks all of the students to place a value on the mug. The students in the first class consistently value the mug at a higher price than the students from the second class. This overvaluation persists even when all the students are provided with the current selling price of the mugs at the university book store.    

Our previous posting discussed recency bias—the tendency for humans to believe the future will continue much as it has in the recent past. Many investors display this bias via performance chasing, that is, favoring investments that have been performing well recently. Some financial advisors have compared this to driving a car by looking continuously in the rear-view mirror. Your driving will be fine until the road turns.