It is unusual for investors to perceive on their own, a constant tug of war between their cognitive thinking and emotional response. Often, emotional response wins because of inherent human behavioral biases. It is important to ensure that cognitive thinking is not suppressed by emotional response.
Especially for investment-related financial matters as investment assets grow only with the right decisions and discipline. Following are 12 investment biases you must know:
1.LOSS AVERSION BIAS
It is thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. This bias emanates from the desire to avoid the feeling of regret experienced after making a choice with a negative outcome. Investors who are influenced by anticipated regret take less risk because it lessens the potential for poor outcomes. The bull market is alive and well, yet many investors have missed the rally because of the fear that it may reverse course. Loss aversion leads to negativity, which causes investors to put more weight on bad news than on good.
2.GAMBLERS’ FALLACY BIAS
Assume that the NIFTY has closed to the upside for five trading sessions in a row. Investors are likely to place a short trade on the NIFTY Index because gambler’s fallacy makes them believe that chances are high that the market will drop on the sixth day after five consecutive sessions of the upward rally. There may be other reasons why the sixth day will produce a down market; but by itself, the fact that the market is up five consecutive days is irrelevant. In most of the instances, such investment biases trade generates losses.
It is the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses. Investors are often drawn to information that is validated in their existing beliefs and opinions. An investor may have a belief about market conditions and gravitate toward information sources that confirm that belief. Oftentimes, it happens when investors attach an emphasis to the outcomes desired.
4.TREND CHASING BIAS
Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. This tendency is complicated by the fact that some product issuers may increase advertising when past performance is high to attract new investors. However, that investor does not benefit because performance usually fails to persist in the future. After a persistent rally in equity markets, historical returns of equity-oriented products become very attractive and hence the sale of equity products zooms up. This is only because of trend-chasing investment biases.
Human habits are difficult to change. This resistance to change spills over to investment portfolios through the acts of repeatedly coming back to the same stocks, sector and fund instead of researching new ideas. Although investing in companies you understand is a sound investment strategy, having a short list of go-to products might limit your profit potential. The world is full of innovations. Right investment strategy is the one that maintains basic principles of investing. But is also open to incorporate new investment ideas and products while researching and investment product selection.
The bandwagon effect is a psychological phenomenon. Here investors do something primarily because other investors are doing it. It’s a thought process that takes hold when a person doesn’t want to be left out of a trend or a movement. Just because the larger herd is buying a particular stock, fund, sector region, or a type of investment, it doesn’t mean that’s the right move for every investor.
But investors get trapped because of this bias. Warren Buffett became one of the most successful investors in the world who resisted the bandwagon bias. His famous advice, “Become greedy when others are fearful and become fearful when others are greedy” is a denouncement of this bias. Going back to confirmation bias, investors feel better when they are investing along with the crowd. But as Buffett has proven, after exhaustive research, an opposite mentality proves more profitable in the long term.
7.DISPOSITION EFFECT BIAS
This refers to a tendency to label investments as winners or losers. Disposition effect bias can lead an investor to hang onto an investment that no longer has any upside or sell a winning investment too early to make up for previous losses. This is harmful because it can increase capital gain taxes and can reduce returns even before taxes.
This occurs when investors have a preference for familiar or well- known investments despite the seemingly obvious gains from diversification. The investors may feel anxiety when diversifying investments away from known investments like FDs, Gold and Real estate; and to
9.SELF – ATTRIBUTION BIAS
Investors who suffer from self-attribution bias tend to attribute successful outcomes to their own actions and bad outcomes to external factors. They often exhibit this bias as a means of self-protection or self-enhancement. Investors affected by self-attribution bias may become overconfident. Investors who live under this belief have trouble coming to terms with the irrationality, variability of markets and the impossibility of their expectation. The outcome is typically a spiral of financial disasters. While they think their belief is correct.
10.MENTAL ACCOUNTING BIAS
Mental accounting occurs when a person views various sources of money as being different from one another. Money earned at a job may be viewed differently than money received as a gift or inheritance. This can affect the way the money is spent or invested. Which leads to the reckless spending of the money which was not earned and was received in form of a gift in cash or a kind. Have you experienced this? Mental accounting shows up in investor portfolios too. “People get emotionally tied to certain investment”. Have you come across a particular elderly woman who wouldn’t part with a large holding of stock in a local bank initiated by a family member?
It’s a fairly common occurrence.
Investors believe what’s happened recently will continue to happen. It’s no secret that retail investors tend to chase investment often piling into an asset class just as it is peaking and about to reverse lower. Because the investment has been climbing higher recently, investors believe that will remain the case.
Unfortunately, research has shown that it’s essentially impossible to predict which asset class, sector or geographic region will be the top performer in any given year. But past performance is generally the strong driver,
The act of worrying is a natural and common human emotion. Worry evokes memories and creates visions of possible future scenarios. That alter an investor’s judgment about personal finances. Anxiety about an investment increases its perceived risk and lowers the level of risk tolerance. To avoid this bias, investors should match their level of risk tolerance with an appropriate asset allocation strategy.
Hence, make sure you don’t become a victim of any of these investment biases.
Disclaimer: Investments are subject to market risk. This write up is issued by PMS-AIF and is produced for information purposes only. Information and opinion contained in this document are published only for the assistance of the recipient. It is neither a solicitation to sell nor shall it form the basis. Or be relied upon in connection with any contract or commitment whatsoever or be taken as investment advice.