Five behavioural biases in investing that you must avoid
The traditional financial theory holds that markets & investors are rational and have perfect self-control. They are not confused by cognitive errors and consider all available information in the decision-making process. However, this is simply not true for the vast majority. Even disciplined investors make financial decisions that are coloured by behavioural biases that cause them to act on emotion or make mistakes processing information.
Here, we highlight five prominent behavioural biases that have been identified as common among retail traders and which you have to avoid!
Mental accounting: Mental accounting refers to the notion, where people treat money differently, depending on where it came from and what they think it should be used for. That's why most people are more inclined towards spending windfall gains on luxury items but would save that same money if they'd earned it. Even seasoned investors are susceptible to this bias when they view recent gains as disposable house money that can be used in high-risk investments.
By filing money away into different mental accounts, we blind ourselves from seeing that some of the money earned through profits might be put to better use elsewhere. This makes investors stop thinking critically about whether they are paying a reasonable price, which can be a costly mistake.
Loss aversion/endowment effect: Loss aversion is a cognitive bias that describes why, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. Loss aversion refers to an individual’s tendency to prefer avoiding losses to acquiring equivalent gains. Simply put, it’s better not to lose Rs 1,000, than to find Rs 1,000.
Closely related to loss aversion is the endowment effect, which occurs when investors place a higher value on a stock that they own than on an identical stock that they do not own. This type of behaviour is typically triggered with items that have an emotional or symbolic significance. However, it can also occur merely because the individual possesses the object in question. The loss aversion or endowment effect can lead to poor and irrational investment decisions whereby, investors refuse to sell loss-making investments in the hope of making their money back.
Anchoring bias: Anchoring is a phenomenon, where an investor values an initial piece of information too much to make subsequent judgements. For example, if we were to ask an investor where the stock of Infosys would be in three months - many would approach it and look at the stock price today. Based on the current stock price, they would make an assumption about where it will go in three months. This is a form of anchoring bias. When we start with a benchmark and build our sense of value based on that benchmark.
Bandwagon effect: The bandwagon or group effect is something we see very commonly in the investing world. It describes the comfort in something because many people do (or believe) the same. A good example of this effect was seen in the recent hoopla around GameStop (GME). For every investor, who jumped on GameStop bandwagon and made money, there are likely many others, who timed the transaction wrong and lost out. Following the herd can hurt and hence, it is best to analyse and think independently to be successful.
Familiarity bias: This occurs when investors have a preference for certain well-known stocks despite the obvious gains from diversification. Investors have an inclination towards buying stocks that they are familiar with. This may mean buying the stock of their own company or of companies that they are aware of and whose products they commonly use. The familiarity bias prevents the investors from analysing the actual potential of the lesser-known companies and stocks, that may turn out to be more profitable than the familiar options.