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 dont much about the root causes because of which conservatism bias continues to exist.
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.
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 dont end up in the self-destructive mode.
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