Affinity bias. After all, are your financial goals about supporting the company’s attractive social image or earning money?

Affinity bias refers to a behavioural pattern where people buy a product or service not only for practical use but also to convey their values or image. This emotional bias affects investment decision-making by leading investors to choose assets based on their image rather than risk-return characteristics, resulting in suboptimal portfolios. Examples include investing in crypto assets, ESG-related trade ideas, patriotic investing, and complex asset classes to appear more sophisticated. Discover whether you are prone to affinity bias and the extent to which it affects your investment decisions with  PRAAMS BehaviouRisk.

Behavioural economics. What is affinity  bias?

This is a behavioural pattern whereby a person buys a product or service not just because of its practical use but also because it helps to communicate his values or desired image to others. For example, ordering expensive whisky or wine to be perceived as a wealthy connoisseur or buying a Tesla to be regarded as a successful, environmentally conscious individual. 

Affinity bias is an emotional bias, i.e., an error in emotional reactions. Compared to cognitive biases, emotional biases are more difficult to overcome and require permanent discipline, control, and awareness.

What are the consequences and investment risks? 

In the investment decision-making process, affinity bias displays itself in the choice of asset class, particular characteristics, or names of investments. Some people invest in crypto assets to be viewed as modern and smart investors, for the excellent opportunity to tell a story or the fear of missing out. Another group of investors is highly inclined towards environmental, social and governance (ESG) trade ideas because they believe that investing in assets that score highly in ESG rankings conveys an image of them as caring citizens with forward-thinking modern values. One more example is patriotic investing when a person prefers allocating assets to companies operating in his country, region, or city. Many investors also buy the securities of companies because they like their well-communicated corporate values and want to be associated with them: Apple for talented and innovative misfits, Tesla for eco-friendly geniuses and big dreamers, Nike for sports passion and health values etc. Finally, some investors buy hedge funds, derivative products, or other complex asset classes to be perceived as more sophisticated investors. 

The fundamental problem with affinity-driven investing is that the investment decision is not based solely on the asset’s risk-return relationship. An investor’s desire to stand out or communicate a better image of himself has nothing to do with achieving investment objectives within his investment risk tolerance. The bias introduces unnecessary noise and makes the risk-adjusted return of a portfolio suboptimal. Ultimately, it leads to excessive risk-taking or lower returns, or both. For example, almost all crypto assets are very high-risk investments and buying them will increase the portfolio’s risk but not necessarily the return. Additionally, a strong inclination towards patriotic investing dramatically limits the investable universe and renders a portfolio suboptimal. 

What can I do to make my portfolio more efficient?

First, acknowledge that some investment decisions may involve elements of affinity bias. Then, base your investing decisions solely on the risk-return characteristics of a security and its portfolio effect. Nothing else. Studies prove that a company’s attractive social image or appealing marketing campaigns may influence the performance of its securities, but the result is usually short-lived and unreliable. We understand that some investors try to make this world a better place by investing in securities of companies with shared values. We agree that this may be good for the future of the planet, but we warn that it has little to do with rational investing. To promote their values and beliefs, these investors may suffer lower returns while accepting higher portfolio risks.