Usually in investing, we are always preached on how to mitigate our risks. Many investors invest on the basis of tips from any reliable or unreliable sources whereas few focus on building insight via fundamental or technical study of a scrip before investing. But there are many instances where emotions and psychology influences an investor, leading him to take irrational decisions. From the initial stage of the investments cycle, investor behaviour plays a major role and thus even a novice investor should focus on controlling his behaviour and he can generate great returns through his investments. The key mantra to keep oneself afloat in the market is to keep patience and have a control on his temperament. Many investors haven’t got multibaggers overnight, it is the patience they kept over years that bore fruit for them in long term.
Many prominent researchers have demonstrated that when people are faced with complex decision-making situations that demand substantial effort, they have difficulty devising completely rational approaches to developing and analyzing various courses of action. Facing uncertainty and an abundance of information to process, individuals may not systematically describe problems, Instead, individuals may follow a more subjective, sub optimal path of reasoning to determine a course of action consistent with their basic judgments and preferences. Few of the major behavioral biases faced by all the investors including ace fund managers are:
- Conservatism Bias: This is one of the major biases faced by the experts of the field. Basically they stick to their prior views and forecasts and fail to modify their beliefs and actions rationally justified by the new information. Eg: Sometimes avoiding fairly evaluating peers that have performed comparatively well in the market.To avoid this investor should react to new information decisively and individually and if it leads to deviate in action taken previously , should act upon it.
- Confirmation Bias: Investor fishes out only those information that support their beliefs. It is human to give more weightage to things that are in our favour and avoid that are against. It is mainly faces when an investor forms a hypothesis but reason out their experiment in such a way that always confirms to the hypothesis.This can effectively be reduced by effectively seeking out information that challenges ones belief. And thus gathering complete information with all the positive and negatives will lead to better decision making
- Representative Bias: Every new information is classified on the basis of “best fit” approximation in one of the past categories already made, even if the new information does not fit necessarily. Eg: when evaluating companies, investors categorise them as growth companies on the basis of already specified parameters but he should understand that every companies should be seen with different lens and then categorised.This can be avoided if an investor evaluates that already specified category leads to complete analysis of the company.
- Hindsight Bias: Many big fund managers goes through this bias, where they tend to remember their own predictions of the future as more accurate than they actually were. They believe that what has already happened in the past was already predicted and can be further repeated and predictable in the future. When people look back, they do not have perfect memory; they tend to “ill in the gaps” with what they prefer to believe. Thus leading to overestimating the degree to which they predict the investment outcome and thus giving them false sense of confidence. To avoid this, one needs to carefully record and examine their investment decisions, both good and bad, to avoid repeating past investment mistakes
- Anchoring Bias: Investors tend to stick to the estimates and benchmarks that was chosen in the past. It helps them for relative evaluation but then again the anchor should re-evaluated from time to time. Eg: While buying a stock an investor checks its P/E to to see if its overpriced or underpriced as compared to previously formed parameter, whereas actually he should again evaluate the market and the specific industry and the stock to get a correct base P/E to evaluate the scrip.
- Framing Bias: Many companies take advantage of this bias while marketing their products. The investor sees the information differently on the basis of how it is framed. A person answers the questions differently based on the way it is asked, leading to change of preferences between the options.Regarding susceptibility to the positive and negative presentation of information, investors should try to be as neutral and open-minded as possible when interpreting investment-related situation, especially when analyzing company’s annual report.
- Loss Aversion Bias: Investors feel the pain of losing twice then the happiness they have from gaining. Thus leading their focus more towards avoiding losses rather than capitalizing on gains. This leads them to hold them a loss position longer than justified and sell the gaining position earlier than justified as they are scared that their profits will erode. Limit the upside potential of a portfolio by selling winners and holding losers. And also less investment returns due to high trading volumes. A disciplined approach to investment can lead to avoid this bias.
- Overconfidence Bias: Investor becomes overconfident on his limited knowledge and skills when he usually gets the return in lesser time than expected. It generally leadspeople to take credit for their success attributing to their own skill and assign responsibility of their failures on the external factors. This leads to holding poorly diversified portfolio with high risk. Investor should always wait for their portfolio to go through bear cycle to understand its real strength.
- Regret Aversion Bias:Investors try to avoid making decisions that makes them scared of going wrong and resulting to regret. This leads them to hold some scrips longer than justified. This bias can make an investor to stay out of the market when the time is right to buy due to the regret of bad decisions made in the past. Eg: After losing money in the 2008 market crash many investors still suffer the same bias inspite of getting huge investing opportunity in this bullish phase. This can only be overcome by gaining more knowledge and learning from the past mistakes.
- Herd Mentality: Investors follow other investment choices of others as they don’t have belief in their analysis. This is common in new investors, who just follow the insights given by ace fund managers without further analyzing it. This leads to market bubbles or crashes. Retail investors keep watching the market and wait for some big fund house to enter for confirmation and thus many times enter the market at wrong time. To avoid this investor should always go through detailed study of his own as difference of perspective is what keeps the market going.It is not always necessary that experts are always right all the time.
- Endowment Bias: Investors start valuing the asset more when they hold it than when they don’t. This bias comes when an investor holds an asset for a long period or gets it in inheritance. This leads to maintaining an inappropriate asset allocation. To avoid this investor should intentionally try to study the stock through indifferent lens and if necessary reduce his holding.
While investing one should go through this checklist time and again, so that he is confirmed that his portfolio is prone to such biases. There is a very blur line between such irrational decision and the rational decision and investors most of the time remain confident that they are avoiding such biases. But one should constantly ask himself questions against such behavior. Due to such behavioral biases, we all have that bad investment decision side in various degrees, it is through its awareness we can build a defense mechanism and invest successfully.
“The investors worst enemy is not the stock market but his own emotions”
Source- CFA Module