Behavioral Biases in Investing
Investors invest in various asset classes to meet their goals; however, there are several behavioral biases that influence their investment decision. This blog would provide you more insight on such biases.
Anchoring refers to getting fixated on a number or value based on the past information. For example, if price of a dress in a shop is Rs. 1500/-, then you will bargain differently than what you would have bargained if the price of same dress was Rs. 1000/-. In the first case the price of 1500 will become an anchor and in the second the anchor would be 1000.
Similarly, if a person has bought a stock for Rs. 150/- and after that the price starts falling; chances are that he will be anchored to the price of 150/- and will not sell the stock even if it continues the fall, until it is too late.
Confirmation bias is a situation where when you have an opinion on something, you search for shreds of evidence/information that would confirm your opinion and ignore information that doesn’t support that opinion.
For an example, if a person believes that women are bad drivers, then he will cite the example of the reports and incidents that confirms his belief and will ignore any evidence or incident that proves otherwise.
Similarly, if an investor decides to invest in shares of a particular stock then he will research in such a way that confirms his views ignoring the reports which might prove that the stock is not a good investment
Overconfidence bias happens when an individual has overestimated his prediction abilities and his data precision. When overconfident he misjudges his belief. This might, in turn, lead him to face situations for which he is not prepared enough.
For example, in a survey asking people if they think that they are above average drivers, more than 80% said yes, which cannot be true and shows overconfidence of some of the survey-takers.
Similarly, if a person has bought a stock and it goes up after that, then the person might get overconfident about his stock-picking abilities and may invest in a stock without proper research.
It (Recency bias) is a phenomenon where an individual relies more on the most recent information or experience to base the decisions.
For example, an employee performs very well during last 4 months before appraisal, in his final year-end review manager appreciates him and rewards him with good bonus and salary hike even though he did not perform well in earlier months. Here the manager had a recency bias which benefited the employee.
Similarly, if someone has invested in mutual funds in last 2-3 years, he would have got very good returns and would expect to get similar returns in future. This however, may or may not happen and depends on the market performance which is generally cyclical in nature.
Loss aversion bias
Every one of us hates losses, don’t we? Loss aversion bias is a situation where an individual prefers to avoid loss rather than looking at the potential gains that he could make with respect to the risk he takes.
In an experiment there were 100 people to whom an option of
- Get 1000 cash
- Get 2000 cash on winning a lucky dip with 50/50 chances. i.e. 50% of the people who opt for this will get 2000 cash and rest of the 50% will get nothing.
More than 80% of the participants opted for the first option of 1000 cash. This is due to the probability of loss involved in second option even though the participant could get potential gain. This is called loss aversion bias.
For example, an individual avoids equity investments due to the downside risk involved instead he prefers to invest in PPF where his capital is protected though the returns may be lower in long term than mutual funds.
It is said that Hindsight is 20/20. Hindsight bias is a phenomenon which comes out of the belief that past is more predictable than it actually is. This is due to the fact that currently we have more information available about a past event then it was available at the time of the occurrence of the event.
A basic example of the hindsight bias is when, after viewing the outcome of a potentially unforeseeable event, a person believes he or she “knew it all along”, like a stock market crash or boom.
The hindsight bias affects a person’s ability to learn from experience as it hinders the ability to look back on past decisions and learn from mistakes.
Herd Mentality is a phenomenon in which an individual’s decision is influenced by the decision of the majority. This impacts the rational decision making ability.
For example, after a stock market boom everyone wants to invest in shares just because everyone is doing so. While investing in stocks is good, it is important to understand various risks associated with it and how these can be minimized by choosing a suitable mutual fund.
Endowment bias is behaviour when an individual assign a higher value to something when giving it up than the value they would be willing to pay to acquire it.
For example, an investor might not sell a stock when the price falls because he thinks it is valued a lot more than the current price, despite there being a solid reason for the fall in the stock price.
Sunk Cost Fallacy
Sunk cost fallacy is behaviour when someone continues to do something even if it doesn’t provide a favourable output just because they have already invested huge time and resources on it.
For example, you are watching a movie in the cinema hall but after 15 minutes you feel that you do not like the movie, chances are that despite that you will continue and finish the movie because you have paid for the ticket and you do not want to waste the money.
Similarly, many a times people make bad investments, like endowment insurance policies and they continue with them despite better options being available elsewhere just because if they surrender the policy, they might get lesser amount than they invested.
An investor should know all these biases and try to avoid them when making the investment decisions.
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