“When the heart speaks, the mind finds it indecent to object” feels author Milan Kundera. Yet, people like Warren Buffet, have followed their mind and won handsomely in the stock market. This is perhaps explained by Willam Blake’s statement “A fool does not see the same tree that a wise man sees”.
Table of Contents
1. Overconfidence
2. Reducing regret
3. Limited Attention Span
4. Chasing Trends
5. Loss aversion
6. Herd mentality
7. Disposition effect bias
8. Mental accounting
9. Familiarity bias
10. Hindsight bias
11. Self-attribution bias
12. Worry
Conflict is a reality, it is all-pervasive and touches human lives too. The perennial conflict of the mind and the heart often gives rise to a lot of dilemmas. These conflicts are the mother of various behavioral patterns that cloud our decision-making ability. We, as human beings are privileged to have a mind that can be applied to make intelligent decisions that are pragmatic and backed by evidence, yet we often choose to be driven by emotions. Our investment decisions are also affected by such biases.
Efficient market theory is a theory that affirms that every stock in the market is priced according to its actual value. All relevant information having an impact on its value is taken care of by the market mechanism and nothing is under or over-valued. If any aberration exists it is due to market inefficiencies.
Advocates of this theory use examples to prove their point. However, people like Warren Buffet, one of the most successful investors of all time, have consistently proved that by adopting value investing strategies, money can be made. So why are disciplined investors able to exploit down stocks consistently and make money, while a lot of others lose heavily? Well, it is because people are often driven by emotions and not by a logical mind. These are behavioral biases which cast a mist on the mind and such biases are taken up for examination:
1. Overconfidence
Larry Kersten advises “Before you attempt to beat the odds, be sure you could survive the odds beating you”. This is useful and timely advice for those overconfident investors who feel that they can beat the market. Overconfidence has two closely linked facets, one is regarding the quality of the information and the other is about the timing of acting on such information for gain optimization.
Market history shows that overconfident investors fail more often than not and also miss out on the opportunity to appropriately diversify their portfolio. The underlying facts emerging from various studies point towards the fact that more active the investor the lesser money they make.
Cure:
Trading less and invest more. Trading is a zero-sum game. It rotates money; it is not generating money. The loss to a trader will be the profit to the other counter party trader. It is wrong to assume that individual intuition and information can beat the market. To resist such an urge.
2. Reducing Regret
This often happens with investors. They feel that they cannot go wrong, can never lose, and thus back a certain stock.
Things do not work out as expected and at some point the stock begins to shed value. Investors still remain steadfast in their belief and refuse to sell. After some more time, the share has lost a majority of its value.
At this point what emerges can be termed as “regret”. However, normal human psychology is to avoid a situation where they are filled with remorse or regret. The investor does not sell in order to avoid facing this feeling of regret and also not able to accept the fact that he has made the wrong decision.
His investment sinks further and he still shies away from selling.
Cure:
Instead of living with the non-performing loss-making investment, booking loss and reinvesting the money in better performing and profitable investmentwill increase the chances of recovery.
“Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks”- Warren Buffet
3. Limited Attention Span
The world is full of options, some lucrative, others not as much. However, in order to choose the coveted options is necessary to have knowledge about them. Most of the time people concentrate or look at only those options which they want to see.
They tend to pay more attention to information that supports their own opinion. They are drawn to information or ideas that prove existing beliefs and opinions. They may have a belief about something, so they find sources that confirm such belief.
The half-knowledge that they gather to serve as the basis for their investment decision thus making them flawed ab initio. Media driven information catches the attention of the investor while they miss out on potentially strong leads that are not covered as vigorously by the media. Half cooked food and half baked information can be harmful.
Often they give importance to the results they desire, maybe investing too much in the shares of the company they work in. This actually reduces diversification.
Cure:
Learning to focus and undertake a thorough analysis of the market in general and specific investments. A good and solid study will help yield opportunities to invest in stocks and mutual funds which are lesser-known but have a lot of promise in delivering good returns. Also, consider information from multiple sources.
4. Chasing Trends
It is like chasing a mirage in a desert. This happens to be the biggest behavioral bias that people are inflicted with. The disclaimer “past performance is not indicative of future results” often fail to deter investors from going ahead with stocks and mutual funds which have performed well in the past. Some increase advertising when the performance is high, to attract new investors.
They think whatever has happened in the past will happen in the future as well. If an investment has been performing well recently, they think it will continue to do so. Unfortunately, research shows its almost impossible to predict which asset class, sector or geographic region will perform well in a given period.
Investors who chase this mirage end up the poorest. Market dynamics are much more complicated and ever-changing parameters ensure that the future is never the mirror of the past.
Cure:
The best antidote to this bias is to follow “Buffettology” or the theory of Warren Buffet. Buy when the markets are low and sell when high. Judge the stocks on merit and act accordingly instead of making decisions based only on past results.
5. Loss aversion
People are more worried about the losses compared to the joy of gaining. Loss aversion is often spoken about when the losses are greater than the profits but sometimes even when the profits are huger, loss aversion is spoken of. They are upset even when they lose lesser money. They remember the losses forever but don’t remember the gains.
Cure:
Discuss with your financial advisor about market expectations and managing emotions during downturns.
6. Herd mentality
Just because all are buying or selling a stock, doesn’t mean that’s the right thing for an investor to do because each has his own objectives. Buying when the market is high and selling when the market is low is a herd mentality. This happens when investors are influenced by peers to follow trends, buy, and adopt a certain behavior, whether it is needed for their financial plan or not.
Cure:
Ask yourself before making a financial decision and see if it matches your financial plan. This can make sure if your actions are right.
7. Disposition effect bias
Here the investors categorize investments into profitable or unprofitable. This makes an investor not to surrender an investment that has no upside or selling a profitable investment too early, to compensate for earlier losses.
Cure:
Don’t sell stocks without a good reason. Buy stocks from long term profitable companies with strong brand value and ignore what media tells at times of crisis. This will help you from being in a panic and selling stocks.
8. Mental accounting
This is when an investor views certain sources of money different from the rest. Eg: Money earned at a job may be viewed differently when compared to money received from an inheritance. This can cause a change in the way the money is spent.
Some people become emotionally attached when owning certain stocks, it may be a gift, something inherited, or a company they work for.
Cure:
Be conscious of your money and also check your spending habits.
9. Familiarity bias
The investors have a preference for familiar or well-known investments despite knowing the gains from diversification. They have anxiety when diversifying with known and unknown investments, as they are not comfortable.
Cure:
To overcome this bias, you need to diversify your portfolio to reduce your risk level.
10. Hindsight bias
The investors are into believing that the onset of the past performances was predictable when that’s not possible. Investors overestimate the correctness of their predictions. This can lead to too much risk-taking and making your portfolio riskier.
Cure:
Remind yourself that the onset of the past performances cannot be predicted. Hence analyze the data and find the possible outcomes.
11. Self-attribution bias
Investors tend to attribute profits because of their own actions and losses to external factors. This is done to protect oneself and one’s self-esteem. They may become overconfident.
Cure:
Analyze yourself. Know your strengths and accept your weaknesses. Knowing yourself can help you form strategies that make you a better investor.
12. Worry
Worry changes an investor’s judgment. Worry or anxiety about an investment increases the perceived risk and lowers the risk tolerance.
Cure:
Investors should find an asset allocation strategy that suits their risk tolerance level.
Conclusion
Perhaps every investor has experienced some or all of the above biases. While it is not possible to wish away all behavioral biases, it is expected that the suggested tips will help mitigate their negative effects.
In order to make better investment decisions and achieve your financial goals without fail, preparing a fundamentally strong, fool-proof financial plan is required. If you would like to create such a financial plan, then I would firmly vouch for you to take advantage of our
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