Investor Bias:The Hidden Hurdle to Investing Right

Who is an “ideal investor”? Perhaps a person who studies the market thoroughly, does all relevant checks on various investment opportunities and always makes a profit on them could be considered an “ideal investor”.

However, such a person does not exist. But it is not the lack of research or careful planning that is to blame – rather it is an investor’s own cognitive and emotional biases that sometimes cause him or her to make irrational money decisions.

Behavioural Economics & the study of ‘Investor Bias’:

Investor Bias came into the limelight in the 1970s when Behavioural Economics and Behavioural Finance began to gain popularity.

So what is Investor Bias? It is basically the irrational financial choices investors sometimes make instead of making informed decisions based on factual information. These choices stem from their own personalities, experiences in life and emotional state of mind.

Types of Investor Bias:

Some biases are fairly common among investors. A few examples are:

1. Overconfidence Bias & Confirmation Bias: Overconfidence Bias occurs when investors are overconfident they have a “tip” nobody else has, and they are making the right investment at the right time. This bias is further strengthened by the Confirmation Bias, where the person only seeks out information that supports his/her view, thus “confirming” it. They ignore any facts that contradict their beliefs, causing them to make faulty decisions

2. Loss Aversion: The Prospect Theory by Daniel Kahneman and Amos Tversky discusses this psychological phenomenon in detail. They observed that many people prefer avoiding losses over gaining equitable profits elsewhere. Such investors hold on to their investments even when they are not doing well – they consider redeeming and reinvesting the money a risk.

3. Herd Mentality: This is an inbuilt human trait – we feel safer following a group. Similarly, investors tend to follow recent, popular market trends or so-called expert tips. They believe if so many others are investing in a particular company, it must be right, leading to Recency Bias or herd mentality. This feeling of ‘safety’ puts them at ease, causing financial disappointments at times.

4. Familiarity Bias: Often, investors buy stocks of companies whose products they like or use frequently. Such familiarity also extends to companies in one’s homeland or city or known brands. This makes them miss out on more lucrative investments in other sectors and may lead to Overconfidence Bias.

The truth is that everyone is prone to one or more of such financial biases to some degree. Most biases are either reflective or reflexive; meaning they are based on past experiences and hindsight, or emotional, spur-of-the-moment decisions. There are also times when the investor makes an error in understanding or processing available information, making miscalculated investment judgments.

Breaking the Bias:

How does one deal with such behavioural biases and take correct investment decisions?

1. Reflect to Realize: The first step - introspect and identify which bias you have. Revisiting your investment history and making an honest appraisal of past investment mistakes can help you detect bias patterns.

2. Break the Pattern: Once you recognize what kind of bias you have unintentionally been following, you can then try to break the pattern.
   
   For instance, if you work in the automobile industry, you might have an Overconfidence Bias or Familiarity Bias regarding investing in the Auto sector. In that case, you may want to explore new avenues you are not too familiar with. Also, try trading less frequently and investing long term instead.
   
   Loss Aversion and herd mentality need a little more effort to get over since they are emotional biases. Keep in mind - investment is all about numbers and real-time performance. As disclaimers regularly remind us, past market movements, popular trends “are not indicative of future results”. Every investor will face losses sometime or the other in their financial journey. However, there are ways to limit those losses, such as setting rules and sticking to them. For instance, you can make a rule not to invest more than 5% of your portfolio in speculative stocks.

3. The Thumb Rule: You may have made a few lucky investments based on your “gut feeling” in the past. But luck is not a reliable financial strategy. Always remember - Do not take major financial decisions on emotions; also look at solid facts.

While completely overcoming these behavioural financial biases is probably not possible, one can try to minimize losses and maximize gains by making slight amends to their investing practices. One way to overcome bias is to have a mixed bag of equity, mutual funds, ETFs, fixed deposits and other investment instruments.

So Stay unbiased with your money and let it grow.

Reference Links:

https://www.investopedia.com/articles/investing/050813/4-behavioral-biases-and-how-avoid-them.asp
https://www.cnr.com/insights/article/white-paper-behavioral-finance-2018.html
https://www.ftadviser.com/investments/2020/12/22/five-investor-behavioural-biases-to-look-out-for/?page=1
https://www.trendfollowing.com/whitepaper/James-Montier-2.pdf
https://www.businessinsider.com/try-this-experiment-yourself-2013-5?IR=T

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.