5 investing biases that lead to sub-optimal returns

Here are 5 common investing biases that can lead to investing errors.

Sep 22, 2020 10:09 IST India Infoline News Service

Bombay-Stock-Exchange-Mumbai
Making money in the stock markets is an art as well as a science. There is a lot of literature written, trying to explain the method of doing so. But, it is very difficult to zero in on the one best idea that will predict a successful outcome.  There is no one-size-fits all formula. However, what does distinguish the ones who were profitable from the ones who failed is their temperament. Human behavior is shaped by conscious and unconscious decisions which can be swayed by behavioral biases. To be a successful investor over the long term, it is critical to understand, and hopefully overcome, common human cognitive or psychological biases that often lead to poor decisions and investment mistakes. If we can identify these biases in our investment process, we can try minimize their effects. Here are 5 common investing biases that can lead to investing errors.

Confirmation Bias: Confirmation bias is the natural human tendency to seek or emphasize information that confirms an existing conclusion or hypothesis. It tends to make us ignore information that goes against our views, and instead seek out information that confirms our beliefs. Instead of accumulating facts and vetting them for relevancy, we start with a conclusion and search for information to verify its validity. confirmation bias is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong.

A credible way to get over this bias is to question our own thesis. We have to find questions and theories that challenges our thesis rather than indulges it. When new information challenges our original investment thesis, it's best to consult the company's financials, read opinions that are opposed to our own, and be honest about our motivations. This just may help us minimize the effects of confirmation bias.

Loss aversion bias: Loss aversion is the tendency for people to strongly prefer avoiding losses than obtaining gains. In simpler terms, people would rather NOT lose Rs100 than gain Rs100. This loss aversion can lead to poor and irrational investment decisions, whereby investors refuse to sell loss-making investments in the hope of making their money back. Investors who become anchored due to loss aversion will pass on potential investment opportunities to retain an existing loss-making investment in the hope of recouping their losses.

To get over this bias, we should understand that losses are a part of investing in stocks. We should create stop loss/exit strategies while an investment and commit to following through with the plan.

Recency bias: This occurs when investors put an emphasis on recent events and give less weight to those that have happened in the past. Although recent information appears fresh and more relevant, it may not always be the case. When looking up information related to investment options online, people sometimes tend to filter out the data pertaining to the past year or the past six months. For example, recency biases can skew an investors’ financial well-being by spurring them into increased risk-taking after experiencing a favorable gain in their portfolio.  It can also occur when the investor experiences an isolated loss and decides not to make any portfolio adjustments for fear of further loss.

The easiest way to overcome this flaw is by taking into consideration historical and present-day data before making an investment decision.

Bandwagon effect or Herd Mentality: Bandwagon bias refers to the practice of investing in a stock or scheme simply because most of the people are doing so. It’s the tendency to follow the crowd to fit in. Speculative bubbles are typically the result of groupthink and herd mentality. Just because the larger herd is stampeding into or out of a stock, sector or region, it doesn’t mean that’s the right move for an investor with his or her own objectives. For instance, when Rakesh Jhunjhunwala invests in a stock, the likelihood is that a lot of people will follow suit—but they won’t have put in anywhere near as much research into the company as the stalwart investor has.
 
Ideally, portfolio decisions should be based on objective, comprehensive research. Making “unpopular” trading decisions, in contrast to the herd, requires bravery, confidence and independent thought; such decisions are more likely to yield desirable results in the long run. 
 
Anchoring bias: Anchoring bias is the likelihood of assigning too much weight to an initial piece of information. Our minds can "anchor" to that information, and it's used as a reference point moving forward, regardless of relevancy. From an investment perspective, one obvious anchor is the recent share price. Many people base their investment decisions on the current share price relative to its trading history. Another example is if you’re researching the best stocks to invest in this year, you may tend to go with the first article that lists out a few stocks. This bias prevents you from learning more and gathering all the information necessary to make informed decisions.

To counter the effects of anchoring, make sure you're not a single-metric investor. We should base our investment decisions on whether or not the share price is trading at a discount to our assessment of intrinsic value and should ignore where the share price has been in the past.
Investing biases can lead people into making financial decisions for reasons other than factual market conditions, significantly diminishing their financial returns. While it’s difficult to remove biases from our lives, there are ways to minimize their impact on our long-term thinking and decision-making.

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