Money and emotions are deeply interconnected. We, humans, are emotional beings and our emotions and feelings have a tremendous impact on our behaviour. This includes financial decision-making. Natural highs and lows of stock markets can impact our emotions and eventually our ability to make rational decisions.
As rightly pointed out by Benjamin Graham in his book “The Intelligent Investor”, “To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework.”
Behavioural biases are thus more common than we think and it is crucial to understand them and how they cloud our decision-making.
What are Behavioural Biases?
Behavioural biases are irrational thoughts and ideas which unconsciously affect our decision-making. There are two types of biases – cognitive biases and emotional biases.
Emotional biases are when we let our feelings be the driver for actions rather than facts or let our emotions cloud our judgment. Cognitive biases occur when we make mistakes while processing and understanding information.
How do biases affect investment decisions?
Biases hamper the ability of an individual to make rational decisions, the bias can be due to emotional reasons like how perceived losses bring twice as much sorrow as perceived gains bring us joy. They are often a result of in-built thoughts and ideas and hamper not only the investment decisions we make but also affect the quantity of wealth that can be augmented.
Some common biases we see in investors are as follows
This bias occurs when investors value the initial or the most recent piece of information received to make investment decisions. Anchoring bias reflects the human tendency to interpret things that confirm our existing beliefs and weed out contradictory notions in the process. It is prevalent in people who find it difficult to challenge their preconceived beliefs.
This bias not only leads to faulty decisions but also creates a false sense of security.
It is important to keep an open mind and be receptive to all kinds of news either positive or negative while investing. Buying a stock that is currently at 52 week low is a classic example of Anchoring bias. Often, one buys a stock just because it has fallen by about 20-30% or more, say, last 3-6 months. Here the investor has incorrectly anchored the stock price to a level before the decline. The stock may fall further and the right anchored price should be the fair value of the stock. While filters like these can be used to consider a stock for investing, they should be further backed by a thorough fundamental analysis of the stock before making an investment decision.
This is seen when people have a preference for a particular stock or asset class and choose to invest in ignoring the benefits of diversification. This is commonly seen when investors find it difficult to leave familiar stocks and industries and invest in up-and-coming sectors or instruments, outside their comfort zones. This kind of investing can lead to contracted risk and lesser gains.
People prefer to invest in gold by purchasing physical units rather than getting the same exposure in a better-controlled manner by investing in gold ETFs. Similarly, people prefer to invest in domestic markets rather than get international exposure.
Trend chasing bias
Investors often believe that history repeats itself, they think that if there were historical gains then the pattern will repeat itself and will lead to future growth. This bias is often exploited by fund houses who say that past gains will be replicated and advertise them to attract investments. This bias has often resulted in bad investments as extraordinary situations are hardly repeated.
This is seen when small crashes happen in the market, people expect the markets to fall as they did in 2008-09 and end up panic selling to avoid losses.
Loss aversion bias
No one likes to lose, but when it comes to investing the focus on avoiding losses is more than making profits. Sometimes the investors act too cautiously which costs them opportunities to add to their wealth. Thus it is essential to mitigate risks while working on creating a diversified profitable portfolio.
Investors often hold investments they are making losses in waiting for a turnaround just to avoid booking losses.
Investors suffering from this bias often tend to associate successful outcomes with themselves and their decisions irrespective of overall market performance and associate bad outcomes with external factors. They do this for self-enhancement purposes and may become overconfident.
This is often seen in cases of market crashes where investors with high-risk portfolios blame everything but their lack of portfolio diversification.
How to avoid biases when investing?
It is important to be first aware that these biases exist and then make efforts to mitigate their risk to your investment portfolio. This will help to construct a sound financial plan and make unbiased investment decisions. Often ordinary investors cannot overcome these biases themselves. Thus, taking the help of a SEBI Registered Investment advisor can help mitigate them. An unbiased investment advisor can help build a proper financial plan based on your risk tolerance and financial goals. They also monitor the investor’s portfolios frequently so that investors need not worry and act in haste due to adverse market movements.
Even when we try to overcome our emotional biases, it is not possible to entirely remove their impact on our financial decision-making. We can however reduce their influence by being more aware of how emotions play a role in the investment choices and make important financial decisions only when we are calm and rational.
Disclaimer: This write up is solely for educational purposes.
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