Investing hinges on buying and selling at the most fundamental level. The basic principle of economics is that human beings as economic agents make rational choices in any market — they choose an option that delivers the most amount of utility of value to them. However, that doesn’t translate very well into the stock market as there’s almost always a severe lack of information on securities.
While price charts and earnings reports are a repository of data, they can never tell an investor everything that he needs to know. As such investing is dependent on lot of experience and intuition. Since these are subjective quantities a lot of our investment decisions are a consequence of a cognitive bias.
Let’s take a look at seven of the most common behavioral biases that drive investment decisions:
1. Overconfidence bias
Investors tend to overestimate their abilities in terms of predicting the price movement of stocks. Not only that, an investor is also susceptible to believing that he/she has better access to information which others might also possess. A study by University of California researchers found that the most active investors made the lowest returns among retail brokerage firms.
Terry Odean and Brad Barber, the authors of the paper written in the aftermath of the dot com bubble, showed that individual investors in the US who traded frequently were worse off than those who made infrequent trades of common stock. They held overconfidence bias as being responsible for excessive trading by the household investors.
2. Endowment effect
This bias has to do with the tendency of people looking to retain what they have. A study found that a group of people were given coffee mugs to keep for some time. When they were asked later for a price for which they will part with the mugs, they quoted it at $7 a piece whereas prospective buyers were ready to shell out a price slightly above $4. The endowment bias in terms of investing means that investors are naturally reluctant to exit their holdings at the right time. They might prefer to stay in a position even after the indicators suggest that the asset should be sold to minimize losses or maximize gains.
3. Confirmation bias
This is perhaps one of the most destructive destroyers of value for investors. While making investment decisions in the market, one needs to read up a lot on many theories and efficacy of indicators. This leads to investors taking a fancy for a school of thought to the extent that they may reject an opinion even when it is backed by good evidence that supports a contraction perspective.
One good example is investors with affinity for gold as a safe harbour. At the slightest hint of the stock market turning choppy, they tend to exit their positions and buy a lot of gold stocks. These investors are generally found to be talking about a stock market Armageddon after every trading session (sic!)
4. Familiarity bias
Human beings are wired to have a preference of things that they know well and are comfortable with. This bias refers to the tendency of investors sticking to modes of investment just because they are familiar with it — resulting in a huge opportunity cost as different asset classes present the opportunity for great value creation at different points of time. For instance, it is quite common in India to invest in SIPs. Of course they are one of the safest investment avenues. However, when the benchmark indices are on a roll and touching new highs every alternate day, you are giving up a huge opportunity to make gains if you choose to stay couched in your comfortable zone of low risk mutual funds.
5. Loss aversion
Several studies have found that the joy of winning is less intense than the fear of losing. Let’s assume that you have invested Rs1 lakh in a stock and booked a gain of Rs2 lakh on it. Another stock that you bought for Rs5 lakh is worth only Rs2 lakh now. Which of the two would you sell if you urgently need Rs2 lakh? According to the loss aversion principle, investors would more often sell the first stock rather than the second one. This is because they have the tendency to stay invested a bit more and see if it can turn into a gainful investment.
According to a 2009 book by psychologists Ori and Rom Brafmen called Sway: The Irresistible Pull of Irrational Behavior, sportspersons often play to avoid losing, rather than to win which makes them vulnerable to opponents looking to exploit the mentality with more aggressive play. Loss aversion manifests most prominently in investing when an investor recalls losses made from a decision more than gains — and steers clear of it despite indication that a particular asset class is ripe for picking.
6. Recency bias
People tend to generally believe that what has been happening will continue to happen. For example, if a company’s share price has been increasing for a few trading sessions, an investor might be drawn to it. However, in doing so he/she could discredit facts such as the company’s fundamentals being not up to the mark and its stock rising due to a general trend of its sector or industry. Most importantly, when the investor enters into a position after a few good trading sessions, the best time might have already passed and a downtrend could be in the offing.
7. Herd mentality
Social media today has become a very important tool of investing as traders pick up chatter about stocks and news from these platforms. The clear disadvantage of this is that along with a lot of fast and useful information, they also get served a lot of noise. This noise could be fake news like the instance in 2013 when the markets crashed for a few minutes as a tweet claimed that US President Barack Obama was injured in a bomb blast in the White House. However, more frequently noise also takes the form of what the general opinion about an asset is — traders post about what they are entering and exiting, or why they think a security will turn sweet or sour. This leads many investors to flock to one stock or another in a ‘herd’ without checking the veracity of the claims. Such an approach could result in a lot of value destruction in one’s portfolio.
Over 100 behavioral biases that can hurt investment decision-making have been identified by researchers, according to Michael Pompian, founder and partner at Sunpointe Investments and author of “Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases.” It could be tough to keep that big a reservoir of emotions in check. Making is however never easy. One needs to practice discipline and introspect regularly to make gains in the capital markets over the long term. That’s what separates the ‘investors’ from the ‘speculators’.