Status quo bias. What do you do when your trade idea goes wrong?

Status quo bias is an emotional tendency where individuals prefer the option that maintains their current situation. It often leads investors to hold familiar securities without proper analysis or rebalancing. To optimise portfolios, one should employ an independent risk management framework, regularly assess financial risks, and consider the long-term impact of transaction costs and taxes. Discover whether you are prone to a status quo bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.

Behavioural science. What is status quo bias?

It is an emotional pattern whereby a person with several choices prefers the option closest to what he already has. In other words, the person is more inclined to make no change in an investment decision or seek to maintain the status quo. This bias resembles and often acts together with loss aversion behavioural finance bias (to risk $1, a person needs at least $2 in exchange to break even psychologically) and endowment bias (a person assigns a higher value to an investment he owns than to the same investment he does not own). Status quo bias is one of the most common among investors and, at the same time, one of the most difficult to eliminate.

Status quo bias is an emotional bias, i.e., an error in emotional reactions. These biases are more difficult to overcome and require permanent discipline and control in addition to awareness.

What are the consequences and portfolio risks?

Firstly, many investors tend to hold securities with which they are familiar or have an emotional attachment. For example, some investors buy Google, Facebook, and Apple stocks because they use their products daily. They confuse the familiar company name with a proper analysis of the risk-return relationship of the company’s security. Secondly, investors with status quo bias tend not to rebalance their portfolios even if this results in excessive risk or offers insufficient returns. Behavioural finance states, that one reason is that they are inclined to avoid any change in the first place. Another is a false perception that transaction costs or taxes associated with buying and selling will be high (usually not). If a person also has loss aversion bias, the effect of status quo bias becomes more pronounced, exacerbating the temptation to avoid losses.
 

What can I do to make my portfolio optimal? 

It is always wise to employ an independent risk management framework that is free of emotional attachments to specific names in your portfolio and can provide a clear numbers-based picture of risks and return. Investing is a long journey; it is easy to lose sight of the end financial goal if there is only one set of eyes, even if you have portfolio management experience. We also strongly recommend regular in-depth financial risk assessments of your portfolio, which should become an essential investment hygiene exercise. Finally, many investors with status quo bias lose comfort when faced with the necessity to pay taxes and incur transaction costs. However, in many cases, these appear small relative to potential underperformance or excessive risk-taking if no due action is taken. Plain numbers usually help a lot.