Behavioural Biases in Investment Decision Making
Everybody has biases. If we know these biases, we can try to avoid them.
Following are some of the major behavioral biases that an investor, knowingly or unknowingly performs making an investment decision:-
Optimism/Confidence Bias –
This is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy. A bias towards optimism often leads investors to have an unrealistically positive view of themselves and their futures. Optimism bias leads many individual investors to overestimate their investment results. To counter this bias, investors need to adopt an outsider’s view when evaluating investment ideas because the insider’s view is usually overly optimistic.
For example, you had a great service interaction with your banker and you will happy to be associated with the bank and because of this optimist, you believe that investments you will/has made in the banking stocks are great and will yield good results, which may not be the case because those are just the person’s optimistic feelings and not analysed findings.
Anchoring Bias –
Anchoring is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgments. Anchoring occurs when an individual lets a specific piece of information control his decision-making process. People often base their decisions on the first source of information to which they are exposed and have difficulty adjusting or changing their views to new information. To avoid anchoring investors should consider a wide range of investment choices and not focus their financial decisions on a specific reference point of information.
For example, many TV viewers prefer a news channel that represents their own political views, avoiding those featuring commentators of different opinions. People do the same when it comes to financial topics. An investor may have a belief about market conditions and may lean towards information sources that confirm that belief. Many investors still anchor on the financial crisis of 2007-2008 as a bad experience.
Loss Aversion Bias –
Also known as regret aversion, loss aversion describes wanting to avoid the feeling of regret experienced after making a choice with a negative outcome (loss). Investors who are influenced by anticipated loss take less risk because it lessens the potential for poor outcomes. Loss aversion can explain an investor’s reluctance to sell losing investments to avoid confronting the fact that they have made poor decisions.
For example, people remember losses forever, but they don’t remember the years they made 30 percent, just years they lost 20 percent. They think that they may experience losses again, and want to avoid the feeling of regret.
Herd Mentality –
Herd mentality is the phenomenon of individuals deciding to follow others and imitating group behaviors rather than deciding independently and automatically on the basis of their own, private information. Professional managers will follow the herd if they are concerned about how others will assess their ability to make sound judgments. Herd behavior can arise as a consequence of rational attempts by managers to enhance their reputations as decision makers. Herd behavior can also be defined as everyone doing what everyone else is doing even when their private information suggests doing something quite different. Herd behavior is affected by different reasons.
For example, it can be said that investors who buy when the market is high and sell when the market is down, and follow all the major stocks as others are more than likely influenced by the herd mentality.
Recency Bias –
Recency bias is a cognitive error that tricks you into believing that what has happened recently will continue to happen again.
When it comes to investing, recency bias often develops in terms of direction or momentum. It convinces us that a rising market or individual stock will continue to appreciate, or that a declining market or stock is likely to keep falling. This bias often leads us to make emotionally charged choices, decisions that could erode our earning potential by tempting us to hold a stock for too long or pull out too soon.
For example, think that a fund would gain 30% in the year 2010 because it had gained about 20% in 2009 and almost 20% in 2008. By the same logic, as the fund returned about 20% in 2017 and roughly 10% in 2016, you’d be inclined to assume that the index will continue to gain in 2018.
Choice Paralysis –
Choice Paralysis occurs when investors experience information overload. Choice Paralysis delays any potential value growth.
Avoiding Choice Paralysis begins with a trusted financial advisor who can present you with a prepared list of the best available options. Their industry and market experience equips them with unique insight to discount bad or even good, but not great, investment options. The end result is a shortened list of exceptional investment opportunities without the exhaustion of information overload. The easiest choice to make is trusting your financial advisor to provide you the best choices available to start building wealth today instead of wondering tomorrow if you made the right choice.
For example, similarly how a restaurant menu, song list, or a full wardrobe, the luxury of wider varieties can often lead to choice paralysis. While choosing from more options can often lead to making worse decisions because of inability to analyze all the options thoroughly.