Category Archive : Basic Concepts

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.

Behavioural biases in nvestment decision making

Financial Life Cycle – What are the stages?

Having a different financial planning strategy for different stages of one’s life can help lay out in very simple words – investing for various tenures of one’s life cycle.
There are six stages of Financial Life Cycle:

  1. Young Unmarried
  2. Young Married
  3. Married with young children
  4. Married with older children
  5. Pre-retirement
  6. Retirement
Stages of Financial Life Cycle
Financial Life Cycle and Risk profile in every stage

Fundamentals of Investing to become rich

3 fundamentals  of investing which can make you way richer than a friend of yours who earns same as you do, but does not invest the way you do.

The 3 fundamentals are:

  1.        Start early      
  2.        Invest regularly    
  3.        Choose the right investment vehicle.

Let us take an example to see how long term investing can work:

Investing in Share Market

Had you invested Rs. 10,000 to buy 100 stocks of WIPRO in 1980, it would have made you immensely rich, see how:

Investing in Wipro shares in 1980 could have made you rich billionaire today
200 shares of Wipro in 1981 would mean owning 1.92 Cr shares in 2017

Today WIPRO’s stock price is 288.60 (as of 15 Dec 2017). So, your holding today would amount to around Rs. 556 crores with a CAGR of 42.94%.

Now, we are not tempting to by WIPRO. This example is like the hen giving golden eggs. We don’t know if any company can give you such returns now. But what we want to stress is long term investing can deliver excellent results.

Private players stepped into the mutual fund industry in 1993. So, MF history is not that old like stocks to quote and example here, but there are funds which have given above 20% CAGR since inception. Now, if the magic MF investing can show in the long term can overpower this WIPRO example or no, is what only time can tell.

Investing in Mutual Funds

Mr. A invests Rs. 1.5 lacs in PPF each year for 35 years. PPF average rate assumed 7.5% p.a.

Corpus created 2.55 crore.

Mr. B invests Rs. 1.5 lacs in small and mid cap funds, giving returns of 15% p.a. for 35 years.

Corpus created 18.57 crore. And some good small and mid cap funds have given returns way above 15% of returns p.a. since inception. So, just imagine the kind of corpus which can be generated

Investing in Mutual Funds or Investing in Equity

According to the report (till 2017 data) by Economic Times, it revealed that only about 4.5% of the total market capitalization in India is held through mutual funds. But, direct stock holding by individuals is nearly 22% of the market capitalization. This shows that the practice of directly investing in stocks is more favorable to a select group of Indians with strong purchasing power.

Choosing between the two kinds of investments depends on a person’s risk taking ability. It also depends upon return expectations and the ability to manage a share portfolio. The recent years have seen a lot of investors move from direct stocks. An increasing percentage of the average Indian population is turning towards mutual funds.

So make sure that you make the right choice between investing in Mutual Funds or Equity.


So invest regularly and see that you invest in the right kind of vehicle. Now, when investment horizon is more than 10 years away, you should invest in small and mid cap funds which have potential to deliver highest returns. Once, category is finalised, choose the best fund on all qualitative and quantitative parameters.

%d bloggers like this: