Psychological Biases That Impact Investment Decisions

Behaviour essentially means the way a person responds or reacts to a stimulus or situation. These behaviours are mostly instinctive. They can either pave a smooth path or be a hindrance in our everyday lives. Having said that, your finances are no exception to instinctive behaviours. Only these are usually called behavioural biases and the study of the same in the field of finance and investments is called behavioural finance.

Behavioural finance deals with the natural biases that people tend to develop when faced with the predicaments of financial investments. Based on these predicaments many investors tend to act out or take irrational or illogical decisions when it comes to investments and finance. This behaviour is beautifully summed up in the prospect theory which states that as human beings our emotional response to losses is much different than to that of gains. The pinch of a loss is felt twice as bad as the happiness of a good gain.

The Psychology behind investing biases is broadly divided into the following categories

Overconfidence Bias:

As the name suggests this bias deals with the overconfident nature of an investor. These investors are usually presumptions and cocky and believe that they can pick out investments that will outperform the markets.

Anchoring or Confirmation Bias:

An investor might hold a particular opinion or preconceived notion and is more likely to seek information that supports his belief or point of view. For example, if an investor believes that a particular fund will do well, he seeks every bit of information that confirms his judgement.

Regret aversion bias:

This bias is also commonly known as loss aversion bias and is usually identified by an investors behaviour of wanting to avoid the feeling of regret usually experienced after making a wrong investment decision. This makes the investor risk avers as he or she tries to mitigate every possibility of a poor outcome.

Disposition effect bias:

This bias is identified by the behaviour of characterizing investments as winners or losers. Disposition bias sometimes drives investors to hang on to investments that no longer serve any purpose or sell an investment too soon, in an attempt to cover previous losses.

Hindsight bias:

Can also be referred to as the knew-it-all-along bias.The perception that an event or occurrence was obvious and could have easily been predicted, when in fact the event was an inconspicuous one.

Familiarity bias:

This occurs when an investor has developed a comfort zone and is unwilling to step out of it. If the investor has developed a preference for certain types of funds for reasons best known to him, he/she might find it difficult to step out of that zone and indulge in diversification in spite of an obvious and visible benefit. This could lead to sub-optimal portfolios with a greater risk of losses.

Self- attribution bias:

A typical and most commonly witnessed bias.  Here the investors tend to attribute success to their own actions while attributing bad outcomes to external factors. They often display a self -enhancement behavioural trait and usually tent to get overconfident.

Trend changing bias:

Many investors often chase past performance under the misconception that past performance is an indicator of future growth or returns. This is not true. In fact, research suggests that investors do not benefit because performance usually fails to persist in the future.

Worry:

The feeling of worry is a natural and a normal phenomenon where investments are concerned. However one must bear in mind that worry can create unreal visions of future possibilities that can severely affect the investment decision. Anxiety caused due to constant worrying increases perceived risk and lowers the levels of risk tolerance. This can hinder investment decisions too. To avoid this bias, investors should match their level of risk tolerance with an appropriate asset allocation strategy.

How to deal with it:

  • Investors are advised to keep the emotion away from investments. This can be achieved by the knowledge and awareness o common behavioural biases mentioned above.
  • Drumming the thought of a prevalent overconfidence trait among investors helps keep this bias in check.
  • Have a clear and thorough understanding of an individual’s risk tolerance and accordingly invest by mitigating risks.
  • Create a methodical and efficient investment plan that can counter market fluctuations even when the markets are down.

The key to great investment decisions and the bedrock of behavioural finance is peace of mind. Keep a calm mind and gain a thorough understanding of your risk appetite and accordingly develop your portfolio. It allows you to gain experience over time and slowly makes you more confident and allows you the vision to look at the bigger picture rather than falling into biased investment patterns.

 

 

Leave a Reply