Cognitive / Behavioral Biases in Investment Journey- Part - I
[A] Introduction: The book - 'The Psychology of Money' has a wonderful message - wealth creation is a function of both - luck and risk. One needs to be 'reasonable' to manage the risk. One should not be over rational, neither should one be too casual with their investments. It is more of an error and trial (semi scientific and semi artistic) process, where one keeps on learning with experience and try to increase the risk adjusted returns, while keeping a margin of safety.
None of us is rational and emotions are all around and in us. No one can run away from them. The same emotions, pre occupations and beliefs also affect our investment decisions. In this article, we will try and explore the biases that do not allow us to take 'reasonable' decisions related to investment.
[B] What is a bias?: According to dictionary.com, "a strong feeling of favour towards or against one group of people, or on one side in an argument, often not based on fair judgement or facts" A bias is a kind of shortcut that simplifies a complex phenomenon so that our brain can make sense of it. It is a kind of belief that is woven into our DNA or hardwired into our brain. Such biases may stop you from taking an informed decision, and landing you in great troubles. Let us look at some of such cognitive biases, which prevent you from taking 'reasonable' investment decisions.
[C] Discussion:
1. Herd Mentality:
'I want to start an SIP in a pharma fund as many of my friends have made a killing out of it.'
'Small caps are very rewarding and I want to invest a big lump sum in it.'
The above decisions basically suffer from what we call as 'herd mentality'. When too many people chase one particular asset class without giving a due thought, leading to a bubble in that space, such behaviour can primarily be referred to herd mentality. For example, all the people started buying houses in 2007, thinking that any investment in housing will fetch very good returns as people saw everyone around buying a house and generating handsome returns.
Your reason to invest in any asset class should be based on your own analysis and portfolio and not because everyone is buying it.
2. Recency Bias: When some people decide to invest in a particular mutual fund, they look at its recent returns (1 to 2 or 3 years of returns), ignoring its historical track record. Now it may happen that certain mutual funds may simply be lucky to have owned a few scripts that clicked in last one year. That may have led to handsome returns. It is not a certificate of the full proof investment thesis of that mutual fund's manager.
We generally take decisions based on the recent or handy information available on any financial product. If you want to analyse a mutual fund properly, look at its 10 year record apart from other aspects like alpha, beta, standard deviation, sharpe etc. If a fund has consistent underperformed in a long run, but has been a super hit in last one to two years, one should not invest in such fund and observe it for more years to learn if it can sustain its recent great performance or not.
3. Confirmation Bias: When you google to find out something related to investment, you may only choose to read the article that reinforces your beliefs or 'confirms' what you already 'know' and 'think that you know'. For example, if you think that XYZ mutual fund is extra ordinary, and you google about its performance, you may stop reading the articles which criticize its fund manager or its performance while very interestingly read the share the article that agrees with your ideas about that mutual fund. Such biases may force you to stick to the loss making shares or mutual funds for more than necessary periods, thus, exacerbating the problems further.
People suffering from such a bias do not prefer to listen to the conflicting views about their investment thesis.
4. Loss Aversion Bias: 'The way to profit passes through the destination called losses'. 'No losses no profits'. These are some of the quotes that tell us that there is no way to make profits without making losses. But it is well understood that you get more pain to book the losses of Rs. 5000 that enjoying the profit of Rs 10,000. This bias does not allow one to come out of your loss making investment. While, one should not take blind risks, total risk aversion
5. Information Bias: Along with information, comes the misinformation, irrelevant information and too much information. Some investors have a tendency to "read" and "react to" every information they get. They keep on analyzing daily stock movements and indexes. While this type of activities might be bread and butter for a trader, for an investor, "not doing anything daily" is as important as making the right decisions, at the time of investing. One must learn to "ignore" the irrelevant information which one may get in the forms of tips, articles or shows. Just stay focused on your goals and read the information that has any relevance to your goal based investments.
6. Home Country Bias: Most of the investors prefer to invest in their own home country. In other words, they prefer investing in the companies, which are from their home country. Such investors think that the share market of their home country has enough opportunities and may not look at the wonderful opportunities to invest across the globe. For example, India's share in global market cap is believed to be around 3.1%, as per the Economic Times of June 22, 2022. So, an Indian investor, investing only in Indian share market, is effectively ignoring rest of the 97% market. Of course, currently, the SEBI rules do not allow the mutual funds in India to invest abroad (Sebi restricts overseas investments by MFs; what should investors do | Mint (livemint.com)), there are other methods like LRS scheme by RBI that allows one to invest beyond the boundaries of the country.
7. Incentive-Caused Bias: This type of bias is easy to understand. This type of bias in the investors give birth to the 'misspelling' practices. For example, an agent wants to sell you a 'money back policy' and tries to convince you that it is in your best interest. But, it should be noted that, chances are, that this policy might not be in your best interest, but in his/her own best interest! Chances are that, while you may need only a term plan, that may not bring a lot of commission to the agent. Thus, incentive caused bias might motivate a person, who shares tips in a newspaper, to offer the tips on the shares (rating: buy and hold) as his wife or mother might be owning thousands of such shares.
8. Hindsight Bias: When your forecast turns true, you take credit for that. But when your forecast fails, you maintain a learned silence (or mental silence and you may convince yourself that it was impossible to correct forecast that event, which you had wrongly forecasted). This type of bias is called hindsight bias. For example, the price of stock X will rise by 5% in next one month is one forecast and the price of stock Y will rise by 6% in next two months is other forecast. While the forecast for share X hits the target, the forecast for stock Y does not, in fact, its price fall by 10%. In that case, you might offer justification (rather than simply accepting that it was your error of judgement), that it was impossible to take a right call on the prices of Y. Such bias does not allow one to learn from the past mistakes and may prove costly in your long term investment journey.
9. Oversimplification Bias: 'I do not invest in what I do not understand'. is the best way to deal with this type of bias. For example, your friend brings you a 'story' that company X is likely to acquire company Y. That will make company X a market leader, with this much of market share. Hence, you need to buy the share of company X, to not miss the golden chance. Now, the problem is, that, there are too many variables at play, that will decide if company X will really gain the market share after taking over company Y. In other words, it is a very complex problem, that we are seeking to simplify. When we simplify what is inherently complex, and then 'solve' it, we simply arrive at a wrong solution.
10. Overconfidence Bias: Many of the guys out there are 'multibagger specialists' who are so sure in their choice of the 'multiagger' that, you may feel, they would have invested all their hard earned monies in that share only! We are generally more confident about our abilities. When you say that you are 100% sure, chances are, you are only 76% sure. One should not overestimate one's ability and generally view all such recommendations with a strong sense of doubt, even if, such recommendations are based on your own 'research'!
11. Anchoring Bias: When you decide that the future price of a share is 100% function of its current price, you are suffering from the anchoring bias. The Technical Analysis school of thought works on this principle. The recent share price becomes an anchor for such an analysis. The fact is that share prices fluctuate so much that it is too difficult to know if a share is value investment opportunity or a value trap. One should at least use fundamental analysis to complement the technical analysis to keep the anchoring bias away while investing.
12. Other biases: Well, the list of these biases can go on and on. Here are some more biases you may want to explore. Part II of this blog post will cover some of these. Stay tuned!
- Trend Chasing Bias
- Worry
- Familiarity Bias
- Restrain Bias
-Neglect Probability
-Contrast Bias / Contrast Effect
-Liking Bias
-Mental Accounting
[D] How to avoid most of the biases:
To avoid these biases, go for a goal based scientific financial planning, by hiring the services of a SEBI approved financial advisor. To understand what he or she may offer you, you can read my blog on personal finance here: PPF (Practical Personal Finance) Series (ppfbypathikvariya.blogspot.com)
[E] Conclusion: In this article, we discussed about the various biases that do not allow us to make sensible investment decisions, the same way that they do not allow us to make sensible any decisions in any domain of the life like career, relationships, health etc.
