Conservatism Bias

In accounting and in finance, conservatism is generally considered to be a positive quality. However, studies in behavioral finance have shown that this may not be the case. This is because conservatism bias is one of the most profound biases which impact the investment decisions of an average investor.

In this article, we will understand what conservatism bias is and how it can adversely affect the investor over due course of time.

What is Conservatism Bias?

In accounting, conservatism means that if two values of an asset are present, the accountant recognizes the lower value. Hence, the principle of conservatism is based on how an investor is supposed to react when they receive multiple and often contradictory reports about the same asset.

This is the case in behavioral finance as well. However, it has been observed that investors often form a deeply emotional view about an investment. This view may be positive or negative. However, it is developed earlier. Then, when the same investor is presented with information that is contradictory to their view formed earlier, they simply discount the new information and hang on to their original opinion. Sometimes, investors may not react to new information, and other times, they may react very slowly.

For example, investors may have a belief that a company like Enron is a good investment. Hence, when early information about the possibility of a scam in Enron came to light, a lot of these investors stuck to their previous views and were slow to react. In the process, the details of the scam became public, and some investors lost a huge portion of their investment.

The Root Cause of Conservatism Bias

As investors, we are aware that conservatism bias does actually exist in the marketplace. We have experienced it ourselves, or we may have come across others who have experienced it over time. However, we don’t much about the root causes because of which conservatism bias continues to exist.

• Failure to Revaluate Complex Data: The first and foremost reason is that formulating an opinion on the financial position of a company is a complex task. The investor has to go through a wide range of financial information and critically analyze the same before they can make any decisions. This process is both arduous as well as time-consuming. The problem is that whenever new information about the company comes out, the investor is supposed to perform the entire analysis again. This can be physically as well as emotionally stressful for the investor. Hence, instead of forming new opinions, the buyers simply hold on to pre-existing beliefs about the firm.

• Cling to Forecasts: Investors have an innate need to feel validated. When investors go through results, very few of them are objectively viewing the results. Instead, they are validating their own beliefs. Hence, if an earlier forecast provided by the company or critics matches with their beliefs, they tend to hang on to that belief instead of reformulating their beliefs. If an investor reads a hundred-page report, they are more likely to remember the four or five pages that validate their belief.

• Slow to React: The initial belief of the investor is firmly entrenched in their mind. Hence, they do not change that belief unless there is overwhelming evidence that their initial belief is wrong. They often take a long time processing the information in their heads. As a result, they are often slow to react. This may cause them to hold on to stocks longer than they should cause erosion in their wealth.

How to Avoid Conservatism Bias?

Just like with all other biases, the key to avoiding conservatism bias is by believing the assumption that we could be wrong and our decisions could be incorrect. Biases tend to hide in our mental blind spots. Hence, if we acknowledge them, the problem is half solved anyway.

• Seek Professional Advice: Many investors believe that they have the necessary financial acumen to make their own financial decisions. However, they still rely on other professionals to help them with decision making. They do so not because they don’t trust in their ability to understand the information. However, they do so because the same information can be interpreted in different ways, given the frame of mind of the interpreter. Hence, it is better to engage a professional who tends to have different views than you. This will help look at facts in a different light, which will help avoid the conservatism bias.

• Act Resolutely: A lot of investors do understand that they are ignoring meaningful information. However, they continue to do so because they are unable to act in a decisive and resolute manner. Whenever new information comes that contradicts their existing beliefs, they tend to dilly-dally and waste time. It is important for investors to be slow to make up their minds. However, once the mind is made up, they should act fast and decisively. This is because, in investment markets, timing is as important as the decision itself, if not more.

The bottom line is that conservatism bias provides another formidable mental challenge for an investor. An investor is required to overcome this challenge so that their wealth keeps on growing, and they don’t end up in the self-destructive mode.