Investment or financial behaviour and actions are driven by how we think. Knowingly or unknowingly, a lot of factors impact our decision-making. There is an entire field of study known as behavioural finance which is the study of the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest, and make decisions based on personal biases instead of facts.
To be a successful investor in the long term, it's highly important to understand and overcome the common psychological biases that typically lead to poor investment decisions and mistakes. Most investors are likely to be influenced by these behavioural biases as they are hard-wired in the subconscious. Even the best of investors sometimes tend to take shortcuts, oversimplify complex decisions and be overconfident in decision-making. A better understanding of your biases will lead you to make better decisions, help you lower risk and improve your investment returns over time.
Following are a few very common yet key behavioural biases that usually leads to a bad investment decision:
Confirmation Bias : It is a human tendency to seek or emphasise information that confirms an existing conclusion or a decision. Confirmation bias leads to investment mistakes as investors typically get overconfident because they keep getting data that appears to confirm the decisions they have made. Overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong. To minimize this bias, one should attempt to challenge the status quo and seek information that causes you to question your investment opinions.
Information Bias : Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. Investors are often bombarded with unimportant & useless information every day, from financial commentators, newspapers and stockbrokers, and it is difficult to filter through it to focus on relevant information only. In general, investors tend to make superior investment decisions if they ignore short-term market movements and focus on the long-term prospects for the underlying investments /asset class and look at their exposure in comparison to those long-term prospects. By ignoring routine market news, investors can overcome a dangerous source of information bias in the investment decision-making process.
Loss aversion/ endowment effect : It is a tendency for people to strongly prefer avoiding losses rather than obtaining gains. Whereas the endowment effect occurs when people place a higher value on a good that they own or have owned than on an identical good that they do not own. Investors refusing to sell loss-making investments in the hope of making their money back is the classic example of the loss aversion or endowment effect. This bias breaks a very important economic rule i.e. the measurement of opportunity cost. To be successful in investments over time; always measure the opportunity cost properly and not be anchored to past investment decisions based on the inbuilt human tendency of avoiding losses.
Bandwagon effect or herd behaviour : The bandwagon effect or herd behaviour describes gaining comfort in something because many other people do (or believe) the same. Speculative bubbles are typically the result of herd mentality. To be a successful investor, you must be able to analyse and think independently, which includes finding no comfort in the fact that other people may or may not agree with your decision. The simple solution is to be objective, factual, grounded and open-minded and not get influenced by fear or greed.
Anchoring Bias : Anchoring bias is the tendency to rely too heavily on or anchor to a past reference or one piece of information when making a decision. Anchoring bias can be hugely damaging to an investor’s research process. From an investment perspective, one obvious anchor is the recent share price. Many people base their investment decisions on the current price relative to its history. Unfortunately, where a price has been in the past presents no information whether a stock is cheap or expensive.
Familiarity Bias : Generally, we prefer things - be it food, people or places which we are familiar with. We like to stay within our comfort zone and hate change or new things. For example, a person investing in traditional investment products like bank deposits takes time to accept equities, even though it is in his best interest. Unknowingly this can push investors away from rational investing where they would prefer asset classes and underlying products of names /industries they are familiar with. In investing parlance, the familiarity bias dissuades us from investing in other assets or investment options that we are not familiar with.
Sunk Cost Fallacy : People often demonstrate a greater tendency to continue an endeavour once an investment in emotions, time, effort or money has been made. This is true when it comes to not just relationships, career, business, etc but the investment choices we make. This is the reason why are we likely to continue with an investment even if it would be rational to give it up. We become attached, we do not cut our losses, and instead, throw good money after bad while refusing to make the rational decision and make good of better opportunities.
Conclusion : The above are only some of the behavioural biases which are frequently quoted in literature. Through experiments, researchers have identified an enormous range of cognitive biases that can apply to financial decisions. For us as investors, we should accept the fact that much of what and how we think is being driven subconsciously by our psychology. These behavioural or cognitive biases, tendencies impacting our financial decision-making can potentially make or break our dreams. There is no doubt that investment behaviour and decision-making is at the heart of investing and the biggest factor for your success.
As wise investors, we should learn more on this interesting subject and aim to control or eliminate these biases, emotions from our decision-making over time. Financial decisions must be factual, data-driven and purely on merits rather than being impacted by anything else. Over time, we should all work towards establishing logical decision-making processes as we mature in our investment journey. The focus should be on the process rather than on the outcome. In the words of Warren Buffet, “investing success doesn’t correlate with IQ after you’re above a score of 25. Once you have ordinary intelligence, then what you need is the temperament to control urges that get others into trouble.” Simply put, it is not the intelligence or knowledge that matters for success – it’s your behaviour that will be the deciding factor.
The above post is a extract from my digital newsletter of December 2021
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