Status Quo Bias
Making a choice can be an overwhelming process. This is particularly true if the person making a choice has to consider a lot of options and then make an informed decision. This is why a lot of times, investors tend to prefer indecision, i.e., sticking to the status quo. In this article, we will explain what the status quo bias is and how it affects decision making.
What is the Status Quo Bias?
The status quo bias is named after the investors tendency to prolong and maintain the status quo. In simple words, this means that if an investor is given a lot of options with many complex and confusing choices, they tend to choose whichever option extends their current arrangement.
The underlying logic behind this bias is that investors are skeptical of change. They view change as a cost and try to avoid it as far as possible till the benefits far outweigh the costs involved. This is the reason why they prefer the status quo when faced with an increasing number of choices. The status quo bias is closely related to other biases such as endowment and loss aversion. These biases often work in tandem. This is the reason why investors often stick with a known investment for many years, even if such an investment provides a lower return over an extended period of time.
How Status Quo Bias Affects Investment Decisions?
Status quo bias can cause investors to hold on to certain stocks. This is particularly the case when the stocks have been received from passive sources such as an inheritance. There are many investors who prefer not to change the stocks in the portfolio, even if such a change would add diversification and make financial losses less likely. The end result is that the investors end up inappropriately holding on to certain investments.
In a lot of cases, investors tend to become personally attached to the investment. This most often happens in the case of real estate investments. Since investors have some memories attached to a particular property, they are often not willing to part with the property even if they get a higher price for it.
People with status quo bias tend to exaggerate the losses that they are likely to face if they change the status quo. For instance, they might exaggerate the tax consequences, the volatility, or some other feature of the investment. This is done in order to justify to themselves that the status quo is indeed their best option. They may minimize the benefits that arise from other options while maximizing the costs in order to create a skewed picture wherein the status quo seems to be the best decision.
Status quo bias causes investors to invest in the same type of securities that they always invested in. For instance, if an investor is comfortable investing in debt instruments, they may continue to do so even though the risk-weighted returns from equity might help them achieve their financial goals faster in the long run.
Status quo bias is associated with an irrational aversion to transaction costs such as brokerage, bid-ask spread, etc. It is true that investors are supposed to avoid these transaction costs in the long run. However, that does not mean that the costs have to be brought down to zero. Transaction costs may not be so bad if the resultant profits help earn more money than what is incurred in the form of costs. Commissions and taxes are typically a small price to pay in order to exit an investment, particularly if it is performing poorly.
How to Avoid the Status Quo Bias?
Status quo bias is often deeply rooted in the psyche of the investor. This is what makes it strong and hence difficult to overcome. However, status quo biases are often the results of the skewed or incomplete analysis. Hence, if the investor takes the services of a middleman who can provide an unbiased analysis, they might be able to avoid the bias. Investors with status quo bias are often rational individuals and will make the right choice if they have the right faces. However, they tend to distort facts, which is why they end up sticking with their current decision. The job of the third party would be to prevent this distortion of facts.
Status quo bias often results from the inability of investors to deal with emotions such as fear of loss and uncertainty. In such cases, emotions end up getting the better of these investors. Hence, financial advisors must also educate their clients about how they must manage their emotions. They must explain that failure to manage their emotions right now could lead to a lower portfolio value, which would cause lifestyle changes in the future.
The bottom line is that doing nothing is much easier and causes no emotional pain. On the other hand, taking a decision involves carefully weighing the pros and cons and then making a decision. It is no surprise that investors have a tendency to prefer the first choice. However, in the long run, this inaction can cause significant losses to the investor.
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