Investing isn’t all about number crunching and rigorous analysis. Although they play a vital role in helping us make investment decisions, it’s important to remind ourselves from time to time of our limitations in behaving rationally all the time. We are humans and often rely on simple, superficial judgments and analyses when faced with a seemingly complex decision.
It may even seem that we are doing our best and taking everything into account, but we may be utterly oblivious to biases and cognitive errors behind the scene. These errors & biases can be costly and not give you the result you were hoping for. However, our biases are what make us human, and rather than ignoring or denying their existence, it’s crucial that we accept and understand them in order to adapt and make better financial decisions in the future.
In this week’s blog, we shall touch upon the common behavioral biases, how they affect you, and the steps you can take to overcome them.
- Herd Mentality: The most prevailing bias you may have come across. Herd mentality is all about following others rather than doing your due diligence. The main reason many of us may be prone to this is the safety aspect. You may feel safer making decisions when you know a large number of people are doing the same thing. In stocks, there is also the fear of missing out on all the gains everyone is making. Although herding may not always lead to disastrous outcomes, investing with your blindfolds on will definitely not lead to successful outcomes either. The best way to avoid herding– do your due diligence. You are investing your hard-earned money. Look at the fundamentals, read reports, understand the industry and the sector. You’ll thank yourself later.
- Anchoring: People rely too much on the initial piece of information when making decisions. That initial piece of information can act as an anchor subconsciously. Think of it this way– a stock you bought has fallen more than 30% – “It’s going to recover,” you think, “The stock is so cheap” It would help to go back to the fundamentals and understand why the stock has fallen so drastically in the first place. Maybe your decision to hold the stock, despite the losses, entirely depends on your purchase value (your anchor) rather than its fundamentals. Similarly, a rallying stock can put investors in the same position. Remember to weigh all information and be open to new information regarding your investments, even if it conflicts with your initial information.
- Mental Accounting: How do you treat your money and investments? Mental accounting means treating your money differently depending upon the source of the funds or the purpose for which it is set aside. Money is fungible, i.e., every rupee has the same value, but we like to think otherwise. Like a bonus is more likely to be squandered considering free money. However, mental accounting can also be seen with regular investors or disciplined spenders. For instance, people will have separate jars/funds to keep aside money for their goals and, at the same time, carry credit card debt. They may place unique value on funds kept for their goals when paying off a credit card debt with double-digit interest makes more sense. People attach emotionally to certain assets and investments when their relinquishment is the most beneficial thing they should do.
This bias is also pertinent when making buy/sell decisions. You are more likely to sell profitable investments when sometimes selling the losers makes more sense. Losing stocks are, first and foremost, a lousy investment, and there is also the benefit of tax-loss harvesting. Loss-aversion also contributes to this bias which is discussed below. People may also divide their portfolios into speculative and non-speculative. They are under the impression that any adverse outcomes of the speculative portfolio may not impact their investments. In fact, the net effect is clearly visible and likely to pull down the overall portfolio.
- Loss Aversion: Loss aversion is the tendency to avoid losses or risks, even if they are negligent or small. People are more likely to avoid investing for fear of incurring losses even though the investment is worth it. You will likely find people saving by putting their money in less risky and less rewarding instruments despite the fact that inflations will likely erode the value of their savings. Taking risks also put investors in a position to yield higher returns. You are more likely to see inflation-beating returns by investing through a well-diversified portfolio of equity stocks.
- Overconfidence: People often overestimate their abilities. We are more likely to assume that our knowledge and analysis are accurate than others. It can lead us to make rash decisions about investments. People prone to this bias are more likely to have lax risk management measures. It can even lead people to think that they may be able to time the market, resulting in nothing but disappointment. As an investor, it’s essential to understand that we can always be wrong and be open to possibilities.
Wishing you all the best with your investments. Stay tuned. See you next week!
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– Nischay Avichal