Behavioral Biases When Investing?

This blog debunks the behavioural biases that could influence the investor's decision making.

There are zillions of investment options in the financial market. All the individuals and investors in the market cannot have the full knowledge of each and every investment option available to them.

Lack of financial information on the side of investors results in the problem of behavioral biases. These are the decisions taken unconsciously by an investor based on his own preferences and judgments.

Investors when faced with complex decisions use personal prejudices due to less information at their end, making decisions as per their own perceptions.

Why behaviour biases matters?

• When Investors understand behavioral biases they can improve their financial outcomes. If the behavioral bias of the investor is identified then he can limit his biases and take the best decision available.
• Investors can know their own behaviour when making decisions or behaviour biases practiced by the clients.

Types of behavioural biases

CONFIRMATION BIAS

Confirmation bias is the urge of investors to remember, favour, and interpret information that matches their previously existing beliefs.

Investors are flooded with information from all around and it gets time- consuming and difficult to process each and every information available to them, therefore some form of bias enters in the decision making process, as information processed by the investor is from his viewpoint.

It becomes a problem when investors remove useful information while investing, ultimately leading to poor decision making.

Example: - Suppose Raj is an investor. He had stocks of XYZ Company, after a year there was a rumour about the company going bankrupt, hearing this news Raj panicked; He searched on the internet and gathered information ignoring the other side where the company launched a new product which increased its revenue.

Acting on the information he gathered from his viewpoint, he sells the stocks of the company which turns out to be a poor decision, as in the same year the stocks of the company reached an all-time high.

Hindsight Bias

Hindsight bias is a phenomenon in which the people gust, they had predicted an event accurately before it happened, giving confidence to people of predicting other events as well.

Once a predicted event becomes true, the investors become overconfident and try to predict the other events in the same manner, often leading to a loss to the investors.

Hindsight bias can also lead to a regret among investors of not taking timely action while investing though they had predicted a particular event rightly.

Example: - with the outbreak of Coronavirus pandemic in India, Sensex lost 1448 points and nifty plunged by 432 points, wiping out several crores of wealth of the investors.

An investor free from hindsight bias can predict the loss he might suffer in the future and can act quickly. He can protect himself from a loss by using hedging or a stop loss order but the investor suffering from hindsight bias may regret not acting earlier.

As on 23rd March, 2020 Sensex further lost 3934.72 points (13.15%) and Nifty fell by 1,135 points (12.98%) at 7610.25, as the situation of recession was feared all over the world.

Being able to predict the loss by the pandemic the investor can become overconfident and might suffer a loss in the future as there were some covid- proof stocks which witnessed profitable growth such as stocks of Maharashtra Scooters, Bharat Electronics, Laurus Lab and so on, therefore the investors should be careful while evaluating their ability to predict how current events will impact the future performance of securities.

Familiarity Bias
In our daily life we meet a lot of people who stick to one decision, they buy a specific brand of clothes, go to the same restaurant and even order the same food. These people are an example of familiarity bias.

In case of familiarity bias, the preference of the people remains confined to what they are familiar with. This behaviour is commonly observed in investors quite often. Investors tend to buy stock or any other asset they are familiar with.

In familiarity bias, investors choose to invest in an investment for which they hold a preference, instead of diversifying their portfolio which can offer viable options to them.

One way to reduce the risk involved in investing is by holding different assets.

For example: - Rohan is an investor who has ₹50,000 for investing. If he invests in a project, let say ‘project A’, then there are chances that he might face a loss of ₹50,000 or can even get a profit, but if a loss occurs, his total amount of ₹50,000 will get wiped out. Therefore, an optimum decision for Rohan is to diversify his portfolio.

Hence, if he allocates ₹50,000 in different projects say projects A, B, C, and D then even if ‘project A’ generates no returns, he can recover the amount from Project B, C, and D.

If an investor had invested in a particular asset, and if that asset had given him good returns, conferring a feeling of being less risky, then the investor will always look forward to investing in such investment.

For example: - when Rohan is given an option to choose between investing in two companies' HSBC financial services and Somany Ceramics decor solutions. He chooses HSBC over Somany Ceramics as he is familiar with HSBC but not Somany Ceramics. His familiarity bias compels him to invest in HSBC financial services, ignoring the potential returns the lesser-known company and stocks can bring.

Biases are the reason the investor takes a wrong decision, and being aware of the biases makes the investor save himself from falling into the trap. So while investing without being influenced by emotions, the investor should make decisions based on his own requirements and investment criteria.

The other biases will be discussed further.