Common Investor Biases
It is very common for an investor to sense a tug-of-war between their analytical brains and their emotions. But sometimes the emotions override the analytics while making the investment decision. This is often due to the behavioural bias, which was created from his past experiences. According to many studies, our different personality traits and preferences, along with a range of emotional and mental behavioural biases, have a strong impact on the way we invest. This is commonly referred to as behavioural finance.
Behavioural Finance is a field of study that studies individual and group emotions, and the impact of their behaviour on the financial markets. This is a multidisciplinary field that includes clinical psychology, psychiatry, organizational behaviour, behavioural economics, accounting, management and the art of judgement.
The concept of behavioural finance helps us recognize our natural biases that lead us to making illogical and often irrational decisions when it comes to investments and finances. A prime example of this is the concept of prospect theory, which is the idea that as humans, our emotional response to perceived losses is different than to that of perceived gains. According to prospect theory, losses for an investor feel twice as painful as gains feel good. Some investors worry more about the marginal percentage change in their wealth than they do about the amount of their wealth. This thought process is backwards and can cause investors to fixate on the wrong issues.
The investment Biases
Behavioural biases hit us all as investors and can vary depending upon our investor personality type. These biases can be cognitive, illustrated by a tendency to think and act in a certain way or follow a rule of thumb. Biases can also be emotional, a tendency to act based on feeling rather than fact. While cognitive biases stem from statistical, information processing, or memory errors, an emotional bias stems from impulse or intuition and results in action based on feelings instead of facts.
Cognitive Biases Anchoring or Confirmation Bias
First impressions can be hard to shake because we tend to selectively filter, paying more attention to information that supports our opinions while ignoring the rest. Likewise, we often resort to preconceived opinions when encountering something or someone new. An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it.
Disposition Effect Bias
This refers to a tendency to label investments as winners or losers. Where the investor sells winning positions and hold onto losing positions. This 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 gains taxes and can reduce returns even before taxes.
According to the modern portfolio theory, as developed by Nobel Prize winning economist Harry Markowitz, an investment should not be evaluated alone, but rather by how it affects the portfolio as a whole. Rather than focusing on individual securities, investors should consider wealth more broadly.
But in practice, investors tend to become hyper-focused on specific investments or investment classes. These “narrow” frames tend to increase investor sensitivity to loss. However, by evaluating investments and performance with a “wide” frame, investors exhibit a greater tendency to accept short-term losses and their effects.
Familiarity bias or Home market bias
This occurs when investors prefer familiar or well-known investments despite the seemingly obvious gains from diversification. The investor may feel anxiety when diversifying investments between well-known domestic securities and lesser known international securities, as well as between both familiar and unfamiliar stocks and bonds that are outside of his or her comfort zone. This can lead to suboptimal portfolios with a greater a risk of losses.
Another common perception bias is hindsight bias, which leads an investor to believe after the fact that the onset of a past event was predictable and completely obvious. This type of investors tend to overestimate the accuracy of their predictions. This can be costly as they get a false sense security when making investment decisions, which can lead to excessive risk-taking behaviour and place his portfolios at risk.
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.
Emotional biases Loss aversion
The risk-taking ability of each investor is different. Some are conservative in their approach while others believe in taking calculated risks. However, among the conservative investors are few who fear losses like anything. They may be aware about the potential gains from an asset class but are intimidated by the prospects of incurring even a short-term loss. In short, their excitement for gains is much less than their aversion towards losses. Needless to say these investors miss out on quite a few fruitful investments.
Regret aversion bias
The regret aversion bias is a continuation of loss aversion bias, it describes wanting 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. Regret aversion can explain an investor’s reluctance to sell losing investments to avoid confronting the fact that they have made poor decisions.
Overconfidence is an emotional bias, where the investors believe they have more control over their investments than they truly do. Since investing involves complex forecasts of the future, overconfident investors may overestimate their abilities to identify successful investments. In fact, experts often overestimate their own abilities more than the average person does. An affluent investor believe that his stock-picking skills were critical to portfolio performance. In reality, they had overlooked broader influences on performance. At its most extreme, an overconfident investor can become involved in investment fraud.
Social influence or herd mentality
Herding is quite an infamous phenomenon in the stock markets and is the result of massive sell offs and rallies. These investors do not put in deep research behind their decisions and only follow the sentiment of the crowd whether positive or negative. Whether it was the tech-bubble in the early 90s, the subprime crisis in 2008, the Eurozone crisis in 2010 or the recent banking sector scams in India, the market has seen huge selloffs. Most of them weren’t even warranted.
Most of the times investors do not want to believe that the stock they have held since ages has become under-performing or they need to sell it off. They are in a constant state of denial. Even through the said asset brings the overall return of the portfolio down, investors are reluctant to part with it.
While we cannot cure the behavioural biases we’re born with, we can certainly try to mitigate their effects. By employing systems intended to counteract these instincts, such as employing feedback, audit trails for decisions, and checklists, we can make more rational decisions and improve the chances of investment success.