The Three Biases All Investors Need To Watch Out For

Behavioral biases are an inherent part of all humans, ingrained in our DNA. With a system of influence as deep as our existence, it is fair to say that our judgments and decisions are often influenced by our biases rather than an objective thought process. Needless to say, it is hard to shed these behavioral biases in a practical way. In fact, the study of preconditioned minds with respect to financial matters is what makes the basis for behavioral finance. 

Let’s take a look at three basic investing biases, how they influence our investing decisions, and what can we do to avoid them.

Herd Mentality

Herd mentality bias refers to the tendency among investors to follow and align investment decisions based on the actions of other investors. This is primarily governed by the fear of either missing out on opportunities or making mistakes. Herd mentality satisfies the intrinsic preference of an investor for conformity.

A paper by IMF reads, “For an investor to imitate others, he or she must be aware of and be influenced by others’ actions." It adds that an "investor herds when knowledge that others are investing changes his or her decision from not investing to making the investment.”

Herd mentality is a strong phenomenon that has created speculative bubbles in specific stocks or broader markets in the past by congregating more and more investors. Similarly, during uncertain times, investors seek comfort by going with the consensus even though it may be panic-driven.

How do we overcome this bias given that common wisdom usually seems right? Perhaps one way is to ask questions and find answers without bias or favor. The ability to analyze and think independently is the key.

Loss Aversion

It is widely seen that the feeling of losing something is worse than gaining the same thing. This phenomena was summarized as, “losses loom larger than gains” by Daniel Kahneman and Amos Tversky in 1979. The paper written by them further said that “aggravation that one experiences in losing a sum of money appears to be greater than the pleasure associated with gaining the same amount.” When the feeling of avoiding losses grows strong, one starts to only focus on how to ‘avoid losses’ at any cost.

The tendency of loss aversion completely overrides the concept of opportunity cost. As an investor, one should ideally gauge the opportunity cost and not just be governed by the predisposition to avoid losses. However, investors driven by the phenomena of loss aversion miss out on better investment opportunities.

At times, investors stuck with a bad investment don’t want to come out of it since is current price is below the price at which it was bought. Such investors keeping focusing on one investment that has lost money while ignoring the other sound investments. In some cases, investors with a loss aversion tendency only invest in safer instruments without realizing the ‘risk’ involved. While such investors are able to insulate themselves from market risks, they end up exposing themselves to inflation risk (reducing one’s purchasing power over the long term).

A good way to circumvent the feeling of ‘loss aversion’ is to understand the concept of opportunity cost, importance of different assets and then build a robust portfolio that can withstand tough times by adopting an asset allocation strategy. Historically, not all asset classes (such as equities, fixed income products, and gold) have fallen or risen at the same time, and hence together, these assets counterbalance the coverall portfolio.

Recency Bias

Good returns are attractive, and no one wants to miss them! Likewise, everyone wants to avoid negative returns. In order to put this into practice, investors tend to fall into the trap of investing in the current best performing asset class, stock or schemes. Similarly, they tend to punish an underperforming asset class (or its subsets). Many times, investors make these decisions because they only see the recent past and fail to look at the longer time period, which might tell a different story. This is recency bias, which occurs when investors prominently emphasize on recent events and give less weight to those that have happened in the past.

This phenomenon plays out in both bull and bear markets. During a bull market, when things look good, and returns look promising, an investor starts to believe that stocks will continue to appreciate in value. This increases their risk appetite and results in them tweaking their portfolios to increase allocation to equities, thereby increasing the risk of the underlying portfolio. The opposite happens during a bear market; falling stock prices and pessimism is what takes charge and risk appetite starts to dry up. Investors often tend to shun equity-oriented products at the cost of jeopardizing their long-term goals.

Recent good or bad news (or events such as the COVID-19 pandemic) in the markets start to become the framework for making investment decisions. How does one cope up with such a myopic view? One needs to have a well laid out financial plan with a clear divide between strategic and tactical asset allocation.

Final Word

Biases tend to undermine a prudent decision-making process and therefore it is important to understand them. Being aware about one’s biases can go a long way in making better investment decisions.

Disclaimer: The report has been carefully prepared, and any exclusions or errors in reporting are unintentional. The author has no position in any stocks mentioned. Investors should consider the above information not as a de facto recommendation, but as an idea for further consideration.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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