Unfortunately, the world around us constantly batters us with noise and news. As a result, the investor is often worried and emotional, ending up making bad decisions.
Each person makes hundreds of decisions every day and thousands every month. Some may be trivial, but those that involve one’s health, money, and investments have a bigger impact.This is why studying behavioural science enables an investor to understand the reasons behind what motivates them and why they make certain decisions.
It also helps them recognise a bad decision, which can pave the way to make suitable amends. In the stock markets, humility helps one recover from a bad investment and recoup the loss by finding an alternate investment.
Hubris on the other hand, has always taken the big and mighty down.
Behavioral science is simply the amalgamation of various subjects such as economics, brain science, human psychology, social studies and economics, but with a focus on how human beings react under various situations.
The most important outcome of this is the understanding of the motivations behind decisions. Since we operate under various influences, the cross-disciplinary nature of behavioural sciences helps identify them and determine which ones are at play.
There are dozens of patterns of such influences, often termed as cognitive biases or emotional biases.
1. Loss aversion:
People are loath to sell stocks that incur losses. It doesn’t matter that exiting a bad stock can enable investing in a better stock. People ignore the much higher opportunity cost, just because they do not want to book the loss.
2. Hindsight bias:
People see past events and recent bull runs as long-lasting patterns. They find a market crash as an unpredictable event. Not having the trouble of a prudent asset allocation, they may incur losses in their portfolios. To overcome this bias, one must carefully note down why they made a certain investment choice and review it often so that they can revisit their decision if the need arises.
3. Confirmation bias:
This is simply sticking to one’s beliefs and overt sense of confidence, often ignoring fresh data. This could be a stock that one feels has always done well and ignoring key risks that emerge around it. In fact the believer often ignores data that does not ‘conform’ to their thinking. To overcome this, one must be ready to jettison old ideas. Charlie Munger once said: “Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire.”
4. Information bias:
This is to over analyse and consider every information available, resulting in analysis paralysis. They may also jump at bad news and quickly sell off a good stock without looking at the big picture. A good investor is able to see the wood from the trees and sifts information skilfully without getting overwhelmed.
5. Incentive-caused bias:
People ignore the power of incentives that middlemen or even some fund managers may have in pushing certain investments. Being aware of this effect helps one evaluate why certain decisions are being made. They prefer to hold investments in products where there is complete transparency. Warren Buffett once said: “Nothing sedates rationality like large doses of effortless money”.
6. Bandwagon effect:
Also called herd mentality, this is dangerous and often leads to investors following others without bothering to do any due diligence. Some popular fund managers even publish their investments goading gullible investors to buy them. Unfortunately the latter are caught napping when the fund manager exits and clears their positions.
7. Anchoring bias:
People lock into a certain price and may miss buying a stock just because it is no longer available at the previous price. People who missed
at 1,000 would be shy of buying at Rs 2,000. Alas for them they still kept watching the stock as it climbed further higher up all the way to 10,000. The key here is to do the research on what is the fair value and future potential of a company rather than naively expecting a set price to hold.
These are just some of the more than 50 investment biases that one can list from literature and the annals of stock market history. To emerge as a successful investor, one must keep emotions in check without being too fearful, overconfident or greedy.
One must practise effective asset allocation, portfolio diversification and rebalance regularly. Rebalancing on a regular basis fosters a disciplined attitude to decision-making by enforcing decisions that could be emotionally challenging, but have the potential to be financially advantageous.
It is essential to comprehend and, ideally, overcome typical human cognitive or psychological biases in investing. These frequently result in poor decisions and investment mistakes.
Such poor decisions lead to poorer portfolios. Because cognitive biases are wired deep down in our brains, we are all vulnerable to oversimplifying complex judgments, taking short cuts, and being overconfident.
Understanding these cognitive biases can lead to better decision making, which is fundamental to lowering risk and improving investment returns over time
(The author is Founder & CEO, Jama Wealth. Recommendations, suggestions, views and opinions are his own. These do not represent the views of Economic Times)