Countering affinity bias

Chas Craig, BridgeTower Media Newswires

Regular readers of this column know behavioral finance topics feature prominently because learning about cognitive errors and emotional biases, eliminating them where possible and accommodating them where they are not, can be an investment edge.

Cognitive errors (e.g., illusion of control bias, hindsight bias and confirmation bias) are primarily due to faulty reasoning and can often be corrected or mitigated with better training. Emotional biases are not related to conscious thought and stem from feeling, impulses, or intuition. Therefore, while cognitive errors are important, since emotional biases are harder to coach out of our humanity, it behooves us to acknowledge their presence and structure investment processes designed to neuter them. While philosophies can be adopted in the abstract, the specific processes used must be customized to the individual given we all have a unique psychological makeup.

Recent columns explored ways to counter the loss aversion, overconfidence, regret aversion, status quo and endowment biases in an investment process. Today we conclude a series on emotional biases as defined by Kaplan. Below the definition of the bias, I offer ideas on how to structure an investment process to mitigate its harmful impact.

Affinity bias – refers to the tendency to favor things that one can identify with emotionally because they are familiar. This bias can lead to irrational decisions because the investor perceives a product or investment opportunity to be a reflection of their values and associations. Ethnic, religious, or alumni affiliations can be the source of affinity bias.

Affinity bias is closely related to the cognitive error of home bias (home bias is usually associated with investors’ inclination to overweight their portfolios in domestic companies), which has been discussed previously. Since most readers of The Journal Record are Oklahoma residents, you’re more likely to have a natural affinity toward the oil and gas industry than the average person. After all, most of us know more about the industry (interplays with overconfidence bias) than the average investor, and most of our minor league sports teams are named to incite boomtown nostalgia.

Consider an investor whose position sizing for individual stocks in an equity allocation typically runs from 4% to 1%, with the higher percentage mostly reserved for companies of the highest quality and firms deemed of more speculative grade usually owned in a lesser proportion. To counter affinity bias the energy inclined investor may choose not to initiate a position in an energy company at more than 1% regardless of their quality assessment.

Beyond combating the affinity bias, in the case of energy companies, this limitation is also helpful in managing overall portfolio exposure levels. The fact is that around the time I was born the energy sector made up about 25% of the S&P, it’s now more like 2.5%. Point being, you can get very overweight to the space quickly. One may be perfectly fine with being overweight in the energy sector from time to time but instituting such a position size limitation would result in doing so via owning a “basket” of companies. Coincidentally, but convenient for my example, given the commoditized nature of the industry, owning one’s energy exposure on a basket basis might make more sense than it would for winner-take-all or winner-take-most type of industries (e.g., search engines and smartphones).

Hopefully this series on countering emotional biases serves as a helpful starting point for readers to think through the problems their unique investor profile presents.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).