What are Behavioral Biases?
Behavioral biases are irrational beliefs that influence behavior and unconsciously impact our decision-making process. Investing decisions are often a result of behavioral biases that make people act on emotions or make errors while processing information. Behavioral finance researchers who study the psychological factors that influence investors’ decisions confirm that investors tend to take mental shortcuts while making complex decisions. These work as escapeways and can bias our judgments whereby we end up making irrational investing decisions. Let us look at six behavioral biases that affect investing decisions along with ways to minimize their influence.
Behavioral Biases In Investing
1. Loss Aversion Bias
People are more sensitive to losses than gains while making investment decisions. If they feel a possibility of loss, they bother not putting their money in the investment basket. They fear losses, although small. This fear will stop them from investing, although the investment’s worth it. They opt for savings, although inflation will decrease the value of money, crumbling down their savings. However, investing could have generated quite a return if invested in a good stock & held for a considerable period. If the time horizon is long, investing in a diverse portfolio of common stocks could be the best option. But people go for low-risk, low-return money market instruments due to stock market volatility.
How To Avoid Loss Aversion Bias?
Remember the basic principle of finance, ‘High Risk Equals High Return and vice versa.’ If you are not willing to take that risk, you won’t earn that profit. You could attempt to adopt some risk by considering assets that generally perform well. Do not get emotionally attached to your investments. Know that risk is a part of investment, and sometimes you don’t have control over it. Being correct all the time while making investments is a myth. So, it’s only logical for you to book a loss and look for other investment options.
2. Overconfidence Bias
Overconfidence bias is a tendency to hold a false assumption of one’s skills, abilities, and knowledge. While confidence is good, overconfidence is bad because you tend to make wrong decisions thinking highly about yourself and your knowledge. People are overconfident about the quality of information they have and the ability to benefit from it. Such investors fail to manage and control their risk effectively. Common behavior showcased by people with this bias is trading frequently and ignoring diversification. Studies show that frequent change in portfolio leads to more loss than gains.
How To Avoid Overconfidence Bias?
An early investor with overconfidence bias could invest in mutual funds. Mutual funds are managed by a team of professionals who invest in securities based on quality analysis and research. Mutual funds have a diverse portfolio as they invest in various sectors, reducing the risk of loss when stocks are volatile in one industry. Another measure to minimize the influence of this bias is to trade less and invest more. While trading, we’re up against institutional investors who have access to more data and experience than we do. So, it is better to expand your time horizon and enjoy dividends from investments.
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3. Anchoring Bias
Anchoring bias describes the subconscious use of irrelevant information. For instance, you take the purchase price of a security as an anchor (fixed reference point) for making subsequent decisions regarding that security. So, a person might hold on to a security longer than they should because their reference point is the price they bought it at, which might be higher than the price of the stock today. Sticking to an initial piece of information to make judgments and decisions regarding the security (when to buy and when to sell) will provide a false analysis since you are relying on a single piece of information while neglecting several other factors.
How To Avoid Anchoring Bias?
Anchoring may happen when you are pressured to make a quick decision. Therefore, delay your decision. Use this time to accumulate information from several reliable sources. Also, do your research. Decisions must never be based on one sole factor. One should be open to new information, although it does not align with the initial information one is relying on to make decisions. Lastly, rely on metrics rather than emotions.
4. Herd Mentality Bias
This bias is seen mostly in people who have stepped into the world of investing without acquiring basic financial knowledge. Ultimately, they show the behavior of sheep, i.e., moving along with the herd/crowd. They experience FOMO, which is an acronym for Fear of Missing Out. Since everyone is buying that one stock, they will also purchase it thinking they might lose future benefits if they don’t do so. Hence, their decisions are encouraged by the herd rather than being based on metrics. Herd behavior can create massive bubbles that eventually burst because prices are not justified by the asset but the investors’ behavior, resulting in overinflated stocks.
How To Avoid Herd Mentality Bias?
You buy a piece of clothing because everyone is buying it in the name of a trend. However, trends change with time, but classics remain forever. To determine such classics, we ought to evaluate the stocks before investing in them. Fundamental analysis is a tool to assess if a company’s stocks are worth investing in or not. Similarly, we must be careful of stocks being promoted online. A good stock does not require publicity. Stock touting is often a tactic used to increase the volume by luring new investors to purchase it. It increases the prices of the stocks, and the pump and dump scheme artists book the greatest profits.
5. Regret Aversion Bias
You do not want to regret a decision you’ve made. For example, you bought a stock for Rs 1000, but the company was fundamentally weak, so soon, the stock price plunged to Rs 500. Regret aversion bias doesn’t allow you to sell this stock; rather, hold it in a hope that the price will increase in the future. Rather than minimizing losses by selling the stock and investing in other assets, you keep holding it, adhering to additional losses. Hence, this bias makes you reluctant to exit an investment by stopping you from changing your investment decisions. According to research, traders were 1.5 to 2 times more apparent to sell a winning position too early and a losing position too late. This allowed them to bypass the regret of losing gains and making losses as it isn’t an actual loss until you’ve finally sold your position.
How To Avoid Regret Aversion Bias?
Determine exit levels for both gains and losses. For instance, if the exit level for your loss is 8%, then you will immediately sell your position when you’ve incurred that percentage of loss on your investment. This is one of the best strategies to avoid regret aversion bias and protect you from severe losses.
6. Trend Chasing Bias
People tend to believe that past performance indicates future performance. They will try to identify patterns and believe it will hold true. Based on this, they make their decisions, i.e., whether to buy, hold or sell a particular stock. Usually, what people believe is, if a stock is showing a price uptrend, it will continue to move up, and when a stock establishes a downtrend, it is rare for it to rise back again. People buy stocks in the first case and sell them in the latter. However, the stock market is volatile, and the trends will change over time. Therefore, you cannot always rely on past performance while investing.
How To Avoid Trend Chasing Bias?
Do not follow the herd. Buy when investors are fearful and sell when investors are confident. This is because when you identify a trend, it is likely that the market players have already identified the trend and taken advantage of it. So, you enter a market thinking you have identified an uptrend, but you are likely buying the stock when it has almost reached its peak, which means you’re contributing to the profit of the market players who bought it way before you did.
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