Conservatism bias. Being stubborn may help in everyday life but not in asset allocation.

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PRAAMS conservatism bias

Conservatism bias is a tendency to stick to prior views or forecasts and to underreact to new information. Investors may cling to outdated data, resulting in slower adaptation and potential losses. Discover whether you are prone to a conservatism bias and how it affects your investment decisions with PRAAMS BehaviouRisk.

Behavioural science. What is conservatism bias?

It is described as a behavioural pattern whereby people tend to stick to their prior views or forecasts and thus underreact to new information. It takes mental effort to process fresh data and update beliefs, and humans are inclined to exert minimal effort unless further information is immediately critical to survival.

Conservatism bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.

What are the consequences and portfolio risks?

A good example is a company issuing a new earnings forecast that sharply contradicts the previous one. An investor displaying conservatism bias will underreact to the revised risk-return relationship by sticking to the old forecast rather than making investment decisions based entirely on the updated risk analysis. Another example is a stock market analyst stubbornly sticking to his previous estimates. Typically, analysts start changing the grounds for their trade ideas only when confronted with overwhelming evidence of the opposite. Consequently, blindly following analysts’ recommendations exposes investors to a different aspect of conservatism bias.

Investors heavily prone to conservatism bias tend to cling inflexibly to their views and react and stressfully adapt slowly to new information and risk factors. The result is that they base their investment decisions on outdated, and thus erroneous, data and tend to lose more due to higher exposure to short-term market swings.

What can I do to make my portfolio optimal?

The first step is acknowledging that you are prone to conservatism bias. Education and advice can usually eradicate cognitive biases, though conservatism bias is challenging to overcome. This bias makes it difficult for you to acknowledge new facts and update your old beliefs, one of which is conservatism bias itself! As such, it may take some time and effort. That said, the second step is to stop clinging to previous forecasts or views. New information such as drastically negative earnings releases, failed tests of a primary product of a biotech company, and dissolution of significant profitable partnerships should be acted upon instantly and decisively. Generally, once you have processed all the critical relevant information, your investment decision should follow immediately. As a risk-aware investor, once you notice the signs of conservatism bias, you should act consciously when new information contradicts your previous forecast or beliefs, remembering that your typical reaction may not always be rational. Finally, it is wise to seek independent professional investment risk manager advice from someone you know is not inclined to conservatism bias.

PRAAMS conservatism bias

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Rinat Kirdan, CFA. Co-founder and CEO of PRAAMS.

Two decades in financial markets (EMEA, US and Asia), Chief Risk Officer and Head of Research