5 behavioural biases that can impact investment decisions
Let’s begin by defining the term bias and why one needs to understand biases. Simply put, biases are certain beliefs, behaviors or thought patterns which are not backed by any rational or logical reasoning.
What makes understanding behavioral biases so crucial is that investing decisions made while being blinded by such biases can prove to be detrimental to one’s finances. Biased thought patterns can make one think about the possibility of making money where there is little hope for any money to be made and they can also prevent one from exiting from certain avenues despite incurring heavy losses. The fact that one biased decision can hamper one’s entire investment strategy makes it a crucial aspect of investing in the markets.
If one can detect any biases in their decision-making methods while making investments and change their thinking accordingly, they can very well make sound rational decisions.
The name comes from the phrase ‘maintaining status quo’, which just means leaving things as they currently are and resisting anything which will change the way things currently are. Simply put, it is a state of inaction, a tendency to resist change even when the most optimal choice is to change.
One can fall victim to the bias when they hold on to investments which are inappropriate for their risk/return profiles or that the market or economic situation does not favor their allocations. The logical path forward is to assess one’s situation and move in a direction which will be favorable to their financial trajectory, but the fear of uncertainty and the mental fatigue which comes with changing one’s old methodologies prevents such people from making optimal decisions. A possible way of overcoming this is by actively reviewing your allocations against external factors and deciding whether the current trajectory they are following are the most optimal or it would be better to change tracks.
The anchoring bias simply means that one is being over reliant on the first-viewed piece of information, or to a particular reference point and ‘anchoring’ the subsequent decision-making process around it, thus making it the focal point of the entire narrative. Essentially, it involves giving too much weight to first impressions or to a reference point while analysing something, even when it may not be beneficial.
An example of the anchoring bias in action is when investors anchor to the price at which they bought a particular security. It is then likely that any subsequent decisions around this particular security will heavily revolve around the purchase price.
One can possibly overcome the anchoring bias by actively acknowledging its influence in one’s investment decisions and exhausting all available information resources before zeroing down on an information and also adjusting accordingly when circumstances change.
Gambler’s fallacy is said to occur when one incorrectly believes the odds of an event happening increase or decrease based on the outcome of a previous event or set of events, even when all these events are independent of each other and random in nature. In other words, it is the erroneous belief of the probability of something happening, increasing or decreasing as the process repeats.
An example of a Gambler’s fallacy is the tendency of an investor to believe that stock price will now move upwards if it is falling continuously from the last few days. Due to this bias, investors have a false belief that due to the steep fall in the prices, the price is no more likely to fall in the future.
One can possibly overcome the Gambler’s fallacy by constantly reminding themselves that past movements do not correspond to or impact future price action. One should always base their decisions to either buy or sell on accurate information achieved through research around the security.
Mental accounting is said to occur when people value money differently based on some subjective criteria, like the source of money as an example. Mentally segregating money based on what source it was received from is a bias due to the fungible nature of money. This is because all money is created equal and is mutually exchangeable, so one should treat all money as one and the same thing.
A common example of mental accounting is when people put aside a certain amount of money with the motive to invest in particularly risky securities or asset classes. Investors usually call this money “the money you can afford to lose”. Now from the outset, this distinction does make some sense by investing a certain amount of money in risky assets whose loss wouldn’t really impact your long-term financial goals, however, if we look closely, we can understand that this distinction isn’t really real. At the end of the day, it is a mentally created distinction because in essence, all the money is the same.
Mental accounting can become problematic when one starts becoming irrational with their segregation heuristics. Since one cannot completely get rid of mentally categorizing money into different buckets despite such categorizations being helpful to a certain extent, one should always keep an open mind and regularly review their overall portfolio performance.
Simply put, it is the investor’s tendency to exit profitable positions and hold on to loss-making investments if they need to sell their stock portfolio partially. This is in the expectation that those loss-making scrips will turn around soon. And just like every other bias, countering the disposition effect requires one to detach from the emotions and focus on logic by justifying buying and selling decisions based on solid and well-researched information about the security.
In conclusion, there are loads of biases one needs to consider before making any investment decisions and one of the most optimal ways to reduce the influence of biases in your decision-making ability is to extensively research about your investments and constantly review your thought patterns.
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