By Hemanth GorurBehavioural biases are one of the most common occurrences in investment decision making, yet are one of the last things on an investor’s mind. If you have ever bought gold in a rush, or purchased a stock just because all your colleagues bought it, or sold prime land because your gut feeling said it was a bad investment, then you are a victim of behavioural biases.
Behavioural biases arise due to your emotions influencing your investment decisions. If not recognised and harnessed, they can present a real risk to your finances. Let us understand the different types of biases.
How often have you intuitively felt that a certain investment was good or bad? Chances are you don’t like certain types of investment by nature, and prefer only certain other types of investment. What investors tend to do in such cases is to hunt for information that can justify their subjective feeling or decision. This unexplained inclination for certain types of investment and dislike for other types can result in what is called confirmation bias. As an investor, you can be thoroughly misled into making the wrong investment decisions and miss out on potential opportunities that you let go simply because your gut feel told you so.
This bias is also called “herd mentality”, wherein you tend to find acceptance by or support from a group, by aligning your investment decision with that of the group members. Group think is a naturally occurring psychological phenomenon that works to encourage consensus in a group even at the cost of accuracy of decision making and penalises independent thought. In investment decision-making, when you try to conform to a group by mirroring the group’s investment choices, be aware those investment choices may not be fully researched ones, or even worse, wrong. After all, if everyone were to be investing after due research, then everyone would be making money, which isn’t the case in real life.
This is one bias that puts most investors on the wrong track. The human brain accords more weightage to recent events than events in the past. As a result, a recent event exerts disproportionately more influence on your investment decision-making. This makes investors exit after a bearish market and flee to safer investments, or enter after a bullish market has run its course, when in fact they must be doing the exact opposite. Recency bias makes investors forget the golden rule of investment decision-making: Buy Low, Sell High.
If recency bias is the father of bad investment decision making, familiarity bias is the mother. The human mind craves for safety at all times. It is the second important set of needs in Maslow’s Hierarchy of Needs. What this means for an investor is that he or she will prefer the known over the unknown, the familiar over the unfamiliar, the “safe” over the “unsafe”. Like the confirmation bias, this may lead to passing up good investment opportunities without your realising it.
Finally, risk aversion plays a very important role in investment decision making. Investors differ widely in their ability to take risk. An investor has high risk aversion if their ability to take risk is low. On the other hand, they have high risk tolerance (or low risk aversion) if their ability to take risk is high. While risk aversion falls along a continuous spectrum, it helps to think of it this way: When you invest, do you look to maximise returns, or minimise losses? If you are the latter type, then you run the risk of foregoing higher returns, especially when you adopt a portfolio approach to investing.
What matters in investment decision making is only researched opinion, not subjective feelings or emotions. Recognise your biases, research well, and only then dive into investing.
The writer is founder, Hermoneytalks.com