Behavioural Biases in Investment Decision Making

Tags: Wealth Management, Investment Lesson, Mutual Funds, Mutual Fund Basics, Stock market, Budget, Finance, Investing, Personal Finance, Investment, ETFs, SIP, Multi cap

Before discussing asset allocation, it is important to take a detour and discuss behavioural biases in investment decision making. This is also one of the risks the investors must understand. However, this risk is not related to the investments, but the role of emotions in decision making, or in other words the irrational behaviour of investors towards management of money.

Investors are driven by emotions and biases. The most dominant emotions are fear, greed and hope.

Some important biases are discussed below:

• Availability Heuristic

Most people rely on examples or experiences that come to mind immediately while analyzing any data, information, or options to choose from. In the investing world, this means that enough research is not undertaken for evaluating investment options. This leads to missing out on critical information, especially pertaining to various investment risks.

• Confirmation Bias

Investors also suffer from confirmation bias. This is the tendency to look for additional information that confirms their already held beliefs or views. It also means interpreting new information to confirm the views. In other words, investors decide first and then look for data to support their views. The downside is very similar to the previous one – investors tend to miss out on many risks.

• Familiarity Bias

An individual tends to prefer the familiar over the novel, as the popular proverb goes, “A known devil is better than an unknown angel.” This leads an investor to concentrate the investments in what is familiar, which at times prevents one from exploring better opportunities, as well as from a meaningful diversification.

• Herd Mentality

“Man is a social animal” – Human beings love to be part of a group. While this behaviour has helped our ancestors survive in hostile situations and against powerful animals, this often works against investors interests in the financial markets. There are numerous examples, where simply being against the herd has been the most profitable strategy.

• Loss Aversion

Loss aversion explains people's tendency to prefer avoiding losses to acquiring equivalent gains: it is better not to lose Rs. 5,000 than to gain Rs. 5,000. Such behaviour often leads people to stay away from profitable opportunities, due to the perception of high risks, even when the risk could be very low. This was first identified by Psychologists Daniel Kahneman and Amos Tversky. Kahneman went on to win Nobel Prize in Economics, later on.

• Overconfidence

This bias refers to a person’s overconfidence in one’s abilities or judgment. This leads one to believe that one is far better than others at something, whereas the reality may be quite different. Under the spell of such a bias, one tends to lower the guards and take on risks without proper assessment.

• Recency bias

The impact of recent events on decision making can be very strong. This applies equally to positive and negative experiences. Investors tend to extrapolate the event into the future and expect a repeat. A bear market or a financial crisis leads people to prefer safe assets. Similarly, a bull market makes people allocate more than what is advised for risky assets. The recent experience overrides analysis in decision making. For example, a rise in prices of equities will make people think only about a further rise which would lead to more investment being made in equities. This increases the risk. On the other hand, a fall in prices in an asset would make people stay away thinking it would fall further which could lead to loss of opportunities.

• Behaviour patterns

There are different types of people and the factors that influence their lives also impact the manner in which they save or invest. The drive to save more or be regular in investing often come from these personal factors. Behavioural tests are very useful in determining and knowing the kind of personality a person has and this would include whether they are spenders or savers or investors. Knowing this can help in making the right efforts to get the individual to perform the desired ac-on.

• Interest of the investors

Many times, the financial and investment decisions are not guided by the fact as to whether this investment is suitable for a person or not but by the interest of the investor. This can lead to the construction of portfolios which are not suitable for specific people. For example, someone working in the Information Technology industry might just have technology stocks in their portfolio. This leads to a concentration of risk and is something that has to be avoided.

• Ethical standards and boundaries

The presence of ethical principles in the dealing of individuals also has an impact as far as their investment behaviour is concerned. Those following ethical standards are more likely to pay attention to their investments and be disciplined because they tend to follow the norms. This is a big help when it comes to building long term wealth. Trying to take shortcuts might derail the entire investment process and set back the existing efforts.

These are only some of the biases. This is not an exhaustive list. The negative effect of these biases is that the investor does not gather enough information to be able to identify more opportunities or to evaluate various risks related to investment avenues. It is only prudent for an investor to do a detailed analysis as is possible, without taking such shortcuts.

It is important to avoid behavioral biases in investment decisions. To detach emotions from investments, it is better to take the opinion of a third person i.e. Registered Investment Advisor (RIA) or Mutual Fund Distributor (MFD).

Disclaimer:        

The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. All complaints regarding Mutual Fund can be directed towards visit www.scores.gov.in (SEBI SCORES portal). Readers are requested to make informed investment decisions and consult Chaitanya Financial Consultants – 9000628943 / mfd.mmr@gmail.com to determine the financial implications with respect to investing in Mutual Funds.

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

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