Knowledge Series XII : Behavioral Biases in Investment Decision Making
Individual investor’s behaviour is extensively influenced by various biases. Many economist and investment advisors observe that biases in behaviour have been and will always have an impact on the judgement of investors.
Human nature is complex, and behavioural finance studies how emotional, cognitive, and psychological factors influence investment decisions. Individual behaviours and thoughts impact spending, investing, trading, financial planning, and portfolio management. The market is not one person, of course, but it represents the collective actions of individuals whose personal behavioural biases may be more or less dominant depending on their unique experiences.
Every investor or trader wants to be successful in capital markets to achieve their financial goals, but most of the market participants tend to make fewer returns over different phases of market.
For instance, during the last market crash, a lot of people acted and redeemed when they didn’t need the money. It has happened in the past and would happen in the future too. As much as we think we are doing the right thing as per the demand of the situation, the act might turn out to be completely irrational. This is simply because such actions are governed by our cognitive biases and not logic.
To be a successful investor over the long term, we believe it is critical to understand, and hopefully overcome, common human cognitive or psychological biases that often lead to poor decisions and investment mistakes.
Let us understand various behavioral biases :
1. Confirmation bias
Confirmation bias is the natural human tendency to seek or emphasise information that confirms an existing conclusion or hypothesis. Confirmation bias is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong.
- Familiarity Bias
This behavioral finance bias occurs when you really stick with what you know, and it can result in your portfolio not being diversified, therefore leaving you at a greater opportunity of risk. A great example of this would be that if you’re into fitness industry or gym trainer, you will tend to invest in apparel, nutrition companies. We always encourage you to invest in what you know – but make sure you’re branching out, learning new industries, and diversifying your portfolio.
3. Herd Mentality
Doing something just because others are doing is called herd mentality. Even before going to a restaurant or watching a movie, we often rely on the fact what others are saying about it. We read reviews and look at the rating to form an opinion without experiencing it ourselves.
In investment world, investment decisions are often made on bases of what big fund houses or great investors are doing. We start investing in these stocks without considering our own investment horizon. In the process, many investors, who invested in such patterns with a short term horizon, made huge losses.
We suggest not taking decisions based on what is making news headlines. Instead, make a conscious effort to make your own investment decision.
- Loss Aversion
Loss aversion occurs when investors place a greater weighting on the concern for losses than the pleasure from market gains. In other words, losing money is way more painful than gaining it. As a result, some investors might want a higher payout to compensate for losses. If the high payout isn’t likely, they might try to avoid losses altogether even if the investment’s risk is acceptable from a rational standpoint.
Don’t be scared of losing money rather take calculative stock specific risk and avoid over leveraging.
5. Recency bias
Recency bias is a psychological phenomenon where a person can remember something which has happened to them recently compared to the thing that has happened to them a while back. For example, let’s say that an investor has been making a good average annual return in the last 5 years. However, in the last twelve months, his portfolio is not giving good returns. Here, because of recency bias, he might feel negative and may believe that the market and his strategies are not working in his favor anymore. However, this is not the complete reality.
Recency bias is a brain illusion that happens when you see the latest issues. Contact your financial advisor to assist, if you are finding it hard to let go.