Behavioural Biases in Investing

Behavioural Biases in Investing

Behavioural finance studies how subjective behavioural elements introduce distortions in  the individual’s  decision-making  process. These distortions are referred to as behavioural biases that prevent an investor from making rational and well-informed decisions.  

Behavioural biases are split into cognitive and emotional biases.

Cognitive biases

Cognitive biases are related to the functioning of the human brain and our tendency to simply information while processing information/decision making.

Self-serving biases

Individuals have a propensity to label all the good things that happen to us as skill (something we have full control over) whilst bad things are labelled as luck (something we have no control over). During a period of negative returns, an investor may blame a loss of $10,000 due to external factors and not because of an investor’s bad investment choices.

Herd mentality

Individuals tend to follow the majority in everyday decision making. Investors may copy the investment portfolio of a famous renowned figure (i.e., Warren Buffet) but fail to realise differences in experience and risk tolerance

.

Framing bias

Occurs when someone makes a decision based on how information is presented to them. Between two options, option A would offer a $50 gain and option B would offer a $100 gain but with a $50 loss. The investor would choose option A because there is no element of risk even though the returns are the exact same.

Anchoring bias

This type of bias occurs when individuals make decisions based on an initial piece of information. An investor may hold on to an asset because the anchored price($100) exceeds market price ($85) and the investor expects an ROI related to the anchored price.

Emotional biases

Emotional biases occur when individuals act on impulse and intuition rather than fundamental sense.

Over confidence bias

Belief that individuals tend to overestimate their abilities and/or skillset. Some investors may believe that they would be able to gain immense wealth by investing in crypto currency without knowing its volatility related risks.

Endowment bias

This belief states that people are more likely to retain an item that they own and would not purchase the same if they had a choice. Investors are more likely to hold an overvalued stock if it was inherited from one of their family members/relative/friend.

Status quo bias

A form of bias in which people are reluctant to change and would not take any action/effort to move away from an individual’s current state.

Common tips to consider

1.     Make investment decisions only after taking professional investment advice.

This can be done within the guidance of Fund managers, Financial Advisors and Experienced investors.

2.     Focus on the long term potential of a portfolio/stock rather than focusing on short term prospects

3.     Frequently checking stock price movements can lead to the initiation of impulse decision making and can lead to early sell offs leading to potential capital gain losses.

4.     Have a well-diversified portfolio

Investing in a variety of asset classes such as Stocks, bonds, Forex(Foreign Exchange) and gold can help mitigate and hedge against risk. Having a less than perfectly correlation of assets can help diversify risk. At the time of a recession, stock prices are likely to plummet but the demand for bonds and gold may rise since they are effective options at the time of uncertain economic environments.

In conclusion, a knowledge of these biases is gained through experience in investing and being aware of the psychology influencing the decision making of individuals. These biases are commonly seen in beginner investors and would reduce over time with a rational mindset. It is also worth noting that some of these biases may be classified under both emotional or investing biases and are determined as a matter of personal preference.

 By: Udaykumar Priyani | Linkedin