Here is a list of 7 Behavioural Biases affecting Investor Returns:
Behavioural Biases is an important concept in behavioural finance. It answers why investor makes irrational and illogical choices.
Behavioural Biases explain what happens when individuals attach feelings to their investments. It illustrates instances wherein emotions overpower reason & logic.
Emotions may cause erroneous selection of securities. Or at times, it may cause wrongful entry/exit.
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Biased decisions can be dependent on investor personality types. The prospect theory illustrates this. Herein, investor experiences a psychological pain upon a loss. This pain is two times vis-a-vis the happiness on a gain. Despite higher risk-taking capability, he settles for peanuts .
Behavioural Biases can be cognitive or emotional. Cognitive bias is the tendency to invest based on thumb rules. These thumb rules might not be scientific. Emotional bias, on the other hand, pertains to feelings. In this, investors’ decisions are based on emotions rather than facts.
Behavioural Biases can affect anyone. Even the wisest men weren’t spared. In fact, assuming that one isn’t susceptible to errors, itself is a bias. Believe it or not! You too must have placed biased bets. And, mostly, it would have brought misery.
Biases are detrimental for your investments. These cloud your wisdom. These clutter your intelligence. You repeat mistakes unknowingly. A treacherous investment seems lucrative. You need to identify your biases and overcome them.
It would be ideal to look into some of the biases:
Confirmation Bias
Ideally, the investing should be based on facts. But what happens when data is gathered to uphold one’s beliefs?
It causes confirmation bias.In this, the decision-making is done in the reverse order. Your conclusion follows supporting facts.
For e.g. You think that stocks of XYZ company are bound to rally. You justify your argument with a High P/E ratio. The company may have a huge debt burden. This may affect its future margins. But you ignore this.
Here, you try to see what you want to see. You don’t perceive the situation in its original form. You reject information which falsifies your judgment. It’s like putting your rosy glasses on. Then saying that the world is red. While in reality, this might not be the case.
Optimism Bias
An investor needs to be confident in his actions. However, overconfidence makes him vulnerable. He might be too optimistic about his stock forecasts. He might avoid analysing the company fundamentals. He may invest till his positions conforms with current market conditions. It might increase his risk profile beyond the optimal threshold. Such a strategy may render losses to him. But he’s unable to overcome the bias.
For e.g. before demonetization, investors misconstrued that real estate prices will never come down. Most of them had portfolios highly weighted on real estate. As the property prices crashed, those investors suffered heavy losses.
Also read: 7 investing mistakes to be avoided by young investors
Loss-aversion Bias
Loss aversion is the attitude of running away from losses. In their case, the pain of loss is twice much higher than the pleasure of gain. Here, investor avoids risky investments. He refrains investments where the probability of loss is high.
He sticks to low risk-low return investments. Even if he gets into equities, he checks the portfolios repeatedly. He feels threatened with the slightest loss in value. He is oblivious that the volatility eventually smoothens in the long-run.
Avoiding risks in itself is a risky proposition. Loss-aversion investors book profits as soon as rally begins. This fickle-mindedness prevents the portfolio from attaining optimal returns.
Self-attribution Bias
An investor suffering from self-attribution assumes himself as the reason for the good stuff. However, if anything bad happens, then others are to be blamed for that. He may do so to save his skin or for self-enhancement. He believes that he can never commit mistakes. It prevents him from seeking reasons for any loss suffered. It’s because he was not the reason for that. The result will be falling in the same pit repeatedly.
Suppose an investor makes a profit in equity investments due to bullish markets. However, he attributes it to his strategic stock-picking. Conversely, when he loses, he blames the luck instead of his faulty stock-picking.
Self-attribution bias may instil overconfidence in an investor. He might indulge in overtrading and underperformance. He won’t seek feedback from others as there’s a false sense of being excellent.
Choice Paralysis
Ideally, a range of investment options should empower the investor. It should allow comparisons to make the best choice. But what if it paralyse his judgment?
In choice paralysis, too many investment options confuse the investor. It’s like an information overload. He is unable to differentiate the relevant from irrelevant. Ultimately, he ends up choosing an unsuitable investment. It may result in illiquidity and lower returns.
For e.g. during market euphoria, all the investors long/short the same stock even though an array of stocks is present.
Endowment Bias
In this, the investor assigns greater importance to his present holdings compared to securities which he doesn’t own. Consequently, he expects a higher selling price which might motivate him to redeem the investments. Conversely, if the similar security is offered to him for purchase, he might agree to buy the same at relatively lower price.
Such kind of bias is observed towards inherited property or shares received as a gift. The endowment bias occurs because of affection/loyalty developed with the asset over time. This love makes the investor perceive the asset being valuable more than its intrinsic worth.
Sunken Cost Bias
Investors make mistakes and suffer losses. But prudence calls for minimising losses in due course. However, the investor finds it difficult to get rid of his investments. Especially; when he has already invested a lot in that asset before. He gets into a denial mode. He assumes that prices would rise soon.
The under performing stocks would be very much visible vis-à-vis peers. But redeeming would amount to being a loser. He wants to win even at the cost of massive losses. It’s as he fell into the grave. Instead of coming out, he continues to dig even deeper.
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Final Words
Always stay away from behavioural biases. Invest based on facts and data instead of emotions and gut feelings. Be aware of your actions & reactions. You may ask for feedback from your fellow investors. Once you realise that you’ve got some bias, get out of it. You may seek help from an experienced advisor to behave rationally.