Information Bias and Investment Influence
By Anushreya Kondapi
A bias is an illogical preference or prejudice. It is an irrational assumption or belief that warps the ability to make a decision based on facts and evidence. Equally, it is a tendency to ignore any evidence that does not line up with that assumption. It’s a uniquely human foible, and as a result, investors are affected by it as well.
Information is critical to stock investors. To make optimal investment decisions, investors spend tremendous amounts of money and effort to acquire stock-related information that is timely, complete and accurate.
#WHAT?
Information bias is a type of cognitive bias and involves a distorted evaluation of information. Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. The main idea in investing is to see the proper source of information and to carefully evaluate information that is relevant to making a more informed investment decision and to discard irrelevant information. Investors are bombarded with useless information every day, from financial commentators, newspapers and stockbrokers, and it is difficult to filter through it to focus on information that is relevant.
#HOW?
Information bias occurs due to people’s curiosity and confusion of goals when trying to choose a course of action. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.
Daily stock prices or market movements usually contain no information that is relevant to an investor who is concerned about the medium-term prospects for investment, yet there are entire news shows and financial columns dedicated to evaluating movements in share prices on a moment-by-moment basis. Many of the times, investors will make investment decisions to buy or sell an investment on the basis of short-term movements in the share price. This may cause investors to sell highly profitable investments due to the fact that the share price has fallen and to buy into bad investments on the basis that the share price has risen.
In general, investors make superior investment decisions if they ignore daily stock price movements and focus on the medium-term prospects for the underlying investment and look at the price in comparison to those prospects. By ignoring daily commentary regarding share prices, investors overcome a dangerous source of information bias in the investment decision-making process.
Researchers on behavioural finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year. Although financial products often include the disclaimer that “past performance is not indicative of future results,” retail traders still believe they can predict the future by studying the past.
Investing biases can lead people into making financial decisions for reasons other than factual market conditions, significantly diminishing their financial stability. That’s why we believe one of our main responsibilities as financial advisors is to help our clients avoid the cognitive and emotional biases that can lead to faulty investment decisions.