Suppose you are planning to get into investing and become successful in portfolio management in the long-term process. In that case, it is critical that you overcome all human psychological and cognitive biases that lead to investment mistakes.
Biases are often hard-wired. We all have the tendency to take shortcut routes and become overconfident in our overall decision-making process. Information biases lead to better decisions that are fundamental in helping reduce risks and improve returns over time.
So, let us understand what is information bias and how it connects with investing.
What is Information Bias - Table of Contents
What Do You Mean By Information Bias?
Information bias takes place when data or information gained by someone is recorded or measured incorrectly so that it does not reflect the actual truth. This bias can be due to multiple factors, such as simple data collection, a deliberate distortion, or a tendency to filter details that conform to preexisting thoughts and ideas.
Information bias can have a long-term effect on investors’ decision-making and can lead to dangerous investment options. This is because human beings are mostly predisposed to a confirmation and recency bias, among others.
Connecting Information Bias With Investing
Information biases can force investors to take wrong decisions based on irrelevant or faulty data. With the addition of social media, it is now possible to gain access to hundreds of data points from multiple sources. This makes information bias a highly critical issue.
Information biases can also affect investors negatively. For example, when an investor places unrequired importance on a single tweet or Facebook update and ignores the overall company performance or the entire market as a whole. Or when an investor gains information that solidifies preconceived notions about a company and ignores any contradictory evidence.
In some cases, the information used by the investor might not even be relevant to the trading decisions. For example, day-to-day fluctuations in stocks are influenced by external factors such as having a broader market sentiment. This does not necessarily reflect a company’s long-term goals.
In the same sense, a company’s past performance cannot indicate its future, where situations and the economic environment change over time.
What are Some Common Types of Information Biases?
There are three common types of information biases that investors should know about:
- Confirmation bias: The tendency people have is researching, interpreting and gathering other details that need to match prior notions. At any time, if any information goes against the beliefs of the investor, then it is ignored entirely.
- Regency bias: This cognitive error is identified as a part of behavioral economics in which investors incorrectly have the idea that certain events will happen soon. By checking the recent details, they tend to discount any relevant details that are older.
- Asymmetric information: This happens when one party has more transactional information than others. For example, used-car sellers know more about the car than a buyer will. This information, in most cases, can lead to market failure.
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How Can You Avoid Information Bias When Investing?
In order to avoid any information bias when planning your investments, here are some strategies and tips to follow:
- Diversifying information source: When obtaining information and news from multiple sources, this includes those that you might agree or not agree with and can help mitigate the impact of multiple single points of information in the overall investment portfolio and provide better balance
- Limiting exposure to financial information and social media: While exposure to information is necessary, too much exposure can increase the risk of information bias. So, when finding and researching information, it is best to be selective and objective and to check all information.
- Make objective analysis: When gathering and absorbing information, focus more on the financial health and long-term prospects of the business rather than any short-term fluctuations. Keep your long-term investments in mind when taking any financial decisions, and avoid being influenced by greed
- Look for professional advice: When planning your investment portfolio, consult an advisor who can guide you with proper investment decisions.
What are Some Other Biases That Can Affect Investors’ Decisions?
The sector of behavioral finance has identified multiple cognitive biases that negatively affect investment decisions. Some of these include:
Overconfidence: There are two basic aspects, such as the overconfidence in informational quality and the ability to act on those details at the perfect time to gain maximum profits.
Loss Aversion: This refers to a phenomenon where a loss (real or potential) is perceived by investors that is more severe than an equivalent gain.
Short attention span: There are hundreds and thousands of stocks that you can select, but investors do not have the time to look into each one. So, investors tend to look at stocks that garner their attention via media, family, websites, and other sources.
Chasing a trend: This is considered to be one of the strongest biases. Researchers found that 39% of all money committed to mutual funds went into the 10% of funds that performed well in the previous year. People tend to look for patterns and validation of them. When they find a pattern, they often act on it. So, when a pattern is found, the market is more random.
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What Do You Mean By Shared Information Bias?
Shared information bias is the tendency for members of a group to spend time discussing any details that they are familiar with rather than any details they do not know. This can lead to the formation of suboptimal conclusions that can cause the group to take wrong decisions.
Conclusion
Information bias is information or data that does not reflect the true financial state. Any information can become biased for multiple reasons such as errors in analysis or collection of information, any subconscious predilection when gathering information, or a deliberate change in the details.
When it comes to behavioral economics, confirmation bias, recency bias, and asymmetric details are informational based that can influence an investor’s decision negatively. To remove this biasness you need to stay strong, gain the right information from multiple sources, and solicit the advice of experts to minimize the negative effects of information bias.
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Vishnu
Founder & Managing Director of Investor Diary
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