Chapter 11: Behavioral Biases and Common Pitfalls in Investment

Chapter 11: Behavioral Biases and Common Pitfalls in Investment

 

11.1 Behavioral bias

“The financials of a company are so good…but I am unable to understand why a stock is going down?”

“The company has announced better than expected earnings, handsome dividends, but still, the stock has been beaten down by the market.”

“I researched the stock myself and found it expensive at the current price. To my surprise, the stock is still moving up from the last 10 days.”

“I have incurred a huge loss in the market, so now I have decided to stay away from it.”

These are some common statements that we hear on a day-to-day basis. Many people may advise you to avoid the stock market for all these very reasons. But avoiding equity investments is not an option. If achieving financial goals and better returns in the longer term is your objective, then equity investment is a good option. But how does one take smart investment decisions and become a successful investor in the equity market? To be a good investor, you need to understand the investment decision-making process and the psychology behind it.

Let us understand with a simple example:

It is common knowledge that equity has provided good returns in the longer term.  Performances of indices like Nifty or Sensex are testimony to that. But how many investors can claim to have achieved the same kind of returns? Very few.

 What is the reason that investors are unable to get equivalent returns even though a certain asset class may have performed well?  There is a difference between asset class returns and investor returns in that asset class. The reason for this difference is individual behavior towards investment decision making.

We will cover a few behavioral biases that people exhibit while taking investment decisions. It is critical to understand these cognitive or psychological biases and try to overcome them to avoid poor decision making. Understanding these biases will help you reduce investment risks, get better investment returns, and manage money matters efficiently.

 

11.2 Loss aversion

“I want to play it safe. I do not want my capital wiped away. I would rather invest my money in fixed income securities.” - Ramesh’s statement on the stock market.

“I am comfortable with investing in a Bank FD @6.5% p.a. At least my money is growing at a decent rate - why should I look for higher returns that come with risks.” – Suresh’s statement on FD investment

We have seen many people like Ramesh and Suresh, who do not want to invest in the equity market. Despite the fact that equity gives higher returns in the long-term, very few people invest in the market. The reason for staying away from the market is the probability of loss. There is a fear of loss, and to manage this fear, they simply avoid asset classes that have the probability of loss. Ideally, people should take calculated risks and weigh all investment options based on risks and returns. In behavioral finance, this tendency is known as loss aversion.

 

11.3 Present bias

“Investor to his advisor: Can you suggest some stocks which have risen significantly in the past one month?

Advisor: Definitely, but the valuation of those stocks is already stretched; I will recommend other good stocks.

Investor: I want to ride only on those stocks that are already going high.”

There is a tendency to invest in asset classes that are offering good returns in present circumstances. You may have seen that when the equity market starts performing well, many new investors also start investing in markets. Similarly, if gold starts giving good returns, then some investors switch investments from other assets to gold. This tendency is known as present bias. Is it right to invest in such asset classes? The answer is NO. The right way to invest is to first decide on your asset allocation. Asset allocation can be decided on the basis of age, lifestyle, income, financial goals, time horizon, etc. It is advisable to take the help of a qualified investment advisor to fix on your asset allocation. You can deviate temporarily to take advantage of a particular asset class but that move should be calculative.  You should return to original asset allocation percentages soon. It is always better to keep an eye on your financial goals instead of short- term payouts.

 

11.4 Status quo bias

Sanjay is investing a majority of his savings in FDs.

Recently, he met with his advisor who suggested that Sanjay should also go for equity investments. Sanjay also wants to diversify his investment into equity and is familiar with equity investment advantage. But he is unable to take a decision about switching his portfolio to equity and is continuously buying time to do it later. The reason for the delay is lack of confidence and the risk of losing existing returns.

We have seen many people like Sanjay who procrastinate over their investment decisions. This is a very common bias that most of us have. Many investors neither want to disturb their existing investment nor have a discussion on the subject. There are many reasons for that. A few common reasons for this bias are lack of proper advice, poor decision-making ability, lack of confidence, etc. This bias is known as the status quo bias. It is important to review your portfolio periodically and take corrective measures. In today’s dynamic world, investing at the right time is important to earn good returns on your portfolio.

 

11.5 Anchoring bias

Conversation between two investors, Nakul and Ketan.

“Nakul: I bought this stock of ABC Ltd. at Rs.700.

Ketan: I feel you must sell it off. You have made a big mistake. The fortunes of the industry have changed.

Nakul: I know but my cost price is Rs.700 and at present, the stock is at Rs.540.

Ketan: So what? Take the loss. The way the markets are treating such companies, it may fall further down.

Nakul: Yes, I will sell. I will just wait for it to come back to the price that I bought it for.

Ketan: How do you know it will? I don’t think so. Moreover, you need to sell because the industry and the company dynamics have changed. The faster you do it, the better for you.

Nakul: Yes, I know that. I am just waiting for the stock to touch Rs.700.”

These are common conversations that can be heard between investors. Most investors are not willing to sell stocks at a price that is lower than their purchase price. The purchase price of the stock works like an anchor in their mind.  They believe that they have purchased the stock at the right price and it will definitely bounce back to this price. These investors are often unwilling to change their opinion.  This is a very common bias even among experienced investors and is known as an anchoring bias.

It is important to acknowledge mistakes and take corrective action, especially when it comes to investing in the stock markets. As market dynamics change at a rapid pace, it is important to factor in the impact of new information available in the market.

 

11.6 Gambler’s fallacy

“Amit to his friend Vimal:  ABC Ltd.’s stock was continuously going down and it has already corrected from a peak of Rs. 2500 to Rs 1500. I think it was the correct time to buy the stock as it had already fallen by 40%, so I purchased it. To my surprise, the stock is falling further and today, it closed at Rs. 900. I am unable to understand why it is continuously falling and when it will come back to my purchase price.

Vimal: I am also stuck with that stock, maybe it is our bad luck.”

This is a common story with many investors, where they may have purchased a ‘falling knife’ in anticipation that the stock will not fall further. It is important to understand the reason for the fall in stock price before making any investment decisions. Just a fall of 40-50% does not mean that the stock will not fall further. This bias is very common, especially among new investors, and is known as the gambler’s fallacy.

 

11.7 Availability bias

 “I don’t want to invest in stock markets. Many friends have lost money by investing in shares, so it is better to avoid such investments.”

How many times have we heard these types of statements? People tend to take decisions based on information that is available to them easily. This bias, known as the availability bias, is not only limited to investment decisions only but spread across all types of decision-making. We should take decisions rationally by considering all options available to us and by assessing their pros and cons. Investment decision-making should also consider all available investment options and risks and rewards associated with them.

 

11.8 Disposition effect

Assume that you have invested Rs. 5 lakh each in two stocks, ABC and XYZ. After a year, the stock value of ABC Ltd. rises to Rs. 7 lakh but the value of XYZ is down to Rs. 4 lakh. You want some money to be withdrawn and decide to sell the stocks. Which stock you will sell?

Most of us will choose to sell stocks of ABC because we will be able to book a profit. If we decide to sell XYZ, we will need to book a loss. Most investors avoid booking losses on their investments. This anomaly in behavior is known as disposition effect. It relates to the tendency of investors to sell shares whose price has increased while keeping assets that have dropped in value.

Investors are less willing to recognize losses (which they would be forced to do if they sold assets which had fallen in value) but are more willing to recognize gains. This is an irrational behavior, as the future performance of equity is unrelated to its purchase price.

 

11.9 Mental accounting

“I have 10 stocks in my  portfolio, 2 stocks have moved 100%, 4 stocks give negative returns and are down by 25% each and 4 stocks do not  move. I have performed well as a few of my stocks have given returns of 100% and I can control the losses of a few stocks to 25%.”

Many investors are satisfied with the fact that a few of their stocks are earning 100% returns. But the bigger question is “How much are you earning on your portfolio?”

In the above example, the portfolio return will only be 10%, if you invest an equal amount in all the stocks. This bias is known as mental accounting. Ideally, we should focus on portfolio returns and even a small return from all stocks gives higher portfolio returns. In the above example, if 2 stocks give 50% returns, 4 stocks give 10% returns and 4 stocks do not move, the portfolio return would be 11.4%.

It would be better to hold more winners than a combination of big movers and losers in the same portfolio.

11.10 Common pitfalls to be avoided

1. Do not purchase low-priced, low-quality stocks.

2. One should follow a system or set of rules.

3. Do not let emotions or ego get in the way of a sound investing strategy. You may feel foolish about buying a stock at 60, selling it at 55, only to buy it back at 65. Put that aside. You might have been too early before, but if the time is right now, do not hesitate. Getting shaken out of a stock should have no bearing on whether you buy it at a later date. It is a new decision every time.

4. Invest in equities for the long-term and not short-term

 5. Do not make unplanned investments and start without setting clear investment objectives and time frames for achieving them.  

6. Patience is a virtue in investing. Do not panic about existing stocks. Be patient for your stocks to reap rewards.

 7.  Be aware of what is happening in the market. As always, knowledge is power and in investing, it is also a comfort. Dig for more information than just skimming through front-page headlines.

 8. Do not put all your money on the same horse. Diversify your portfolio, ideally into five industries and 10 to 15 stocks.

 9. Margin is not a luxury; it is a deep-seated risk - know your risk profile and use margin trading sparingly. You might lose control of your investments if you borrow too much.

 10. Greed is dangerous; it may wipe out gains already made. Once a reasonable profit has been made, an investor should get out of the market quickly.