The field of behavioural finance points out several beliefs and biases that hamper investment decisions and lead to sub-par investment returns. Individuals as well as sophisticated fund managers, are not immune to these biases and beliefs. They stem from different sources and profoundly impact how we think and go about our investments. While some notions, such as discipline and patience, help in the investing journey, certain biases can prove to be roadblocks in our wealth creation journey. One should steer away from these five biases:
Herd mentality: In behavioural finance, herd mentality bias refers to the tendency to follow and copy what others are doing. The tendency to join the crowd is a common trait, also known as the ‘bandwagon effect’. Example: most funds are focused on beating the index on a consistent basis. So, most of them are either overweight or underweight on a particular sector quite uniformly. This leads to under diversification in the investor’s portfolio despite investing in different funds.
Recency bias: Most investors tend to give more importance to short-term information, instead of weighing investments over longer time periods, across market cycles (bull and bear) and understanding the array of underlying undercurrents in play. This is known as recency bias. For example, if a sector generated exuberant returns in the recent past, investors typically find it difficult to make a significant cut in position size despite extremely expensive valuations and vice versa.
Confirmation bias: This bias comes from the field of cognitive psychology, where one shows the tendency to search for or interpret information and retain it in a manner that matches their preconceived notions or belief systems. This is one of the biggest biases, as most of us are prone to it. For example, if investors believes that the market outlook is positive or bullish, they may look at the data that vindicates this belief and ignores the risks or the headwinds in play. It gives a sense of overconfidence, while fair evaluation is thwarted. After the demonetization and implementation of GST, there was a growing view among investors that organized businesses, especially in the housing and construction sectors, would perform exceedingly well because of gain in market share. The overweight positions were held on to, despite there being no evidence in the quarterly results. This led to losses and/or sub-par performance for a lot of investors.
Loss aversion bias: This bias describes wanting to avoid the feeling of regret experienced after making a choice with a negative outcome. Investors who are influenced by this bias either look for irrational reasons to keep holding on to loss-making investments or completely avoiding taking risks. For instance, people find it difficult to sell investments where they have gotten into a value trap or quality at any price trap, thinking that they have made a great investment decision. They then continue to hold stocks (and even average down) despite financial results not agreeing with their initial thesis.
Familiarity bias: This is the tendency to overvalue or stick to something we already know. This occurs when investors prefer familiar to unfamiliar investments despite the seemingly obvious gains from diversification. For example, investors generally have a comfort zone that is limited to specific stocks and sectors. They may feel anxiety when diversifying investments into unfamiliar stocks and bonds that are outside of their comfort zone. This can lead to suboptimal portfolios with a greater risk of losses.
The first step to overcome any biases is to identify such biases. Recognizing and mitigating biases are essential to making prudent financial decisions. It takes the following few simple steps to eliminate them.
Develop a written investment plan that outlines your goals, strategy, risk tolerance, and asset classes you want to invest in. Follow this plan consistently to avoid impulsive decisions influenced by emotions.
Maintain a long-term perspective and avoid reacting to short-term market fluctuations or news events. Remind yourself of your long-term goals every time there is an impulse to act.
Investing in different funds is not a true diversification. Investors should always look at style diversification like value, quality, momentum, etc. Within style, look for funds that invest systematically on well-defined rules.
Vineet Sachdeva is entrepreneur partner, Alpha Alternatives.
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Updated: 14 Nov 2023, 10:28 PM IST