Chapter 14 - Behavioural Biases and Common Pitfalls in Investment – Part 1

“I made it a point to research the financials of the company. And it was excellent! Then why is it crashing?”

“How does the stock manage to get beaten down by the market when it announced better-than-expected earnings and superb dividends?”

“Oh no! The price of the stock is rising by leaps and bounds. If only I had bought it last fortnight, but I still found it expensive then!”

“Last year's pandemic caused my friend to loose so much money in the stock market that I am too scared to venture in it.”

Have you come across any of these statements? Or perhaps know of someone who may have voiced a similar opinion? These are just some of the many statements that can strike fear in your heart and make you stay away from investing in the stock market.

But if your point is to gain wealth and build a financial future, equity investments is the way to go. In the face of other people's apprehension, fears, rumors, experiences and emotions, how can you ensure you make a smart investment decision and become a wise investor in the equity market?

Pssst. The answer lies behind psychology.

No. We don't mean you need to get a degree in psychology, this chapter will more than suffice in making you wiser and conquering biases.

So, let’s get cracking!

Did you know, your behavioural biases could rob you of wealth-generating opportunities?

But what is a behavioural bias?

It's a psychological behavior that influences your investment decisions.

So does this mean it all boils down to human behavior?

That's right. Most investors give up on the opportunity of earning good returns just out of fear.

Did you know? 

One of the most respected financial writers, Nick Murray, once said, “Investment performance doesn’t determine real-life returns; investor’s behaviour does.”

How can you conquer poor decision-making?

Knowing more about behavioural biases can help you cut down investment risks, receive better investment returns and manage your money matters smartly.

Let’s understand the following biases one by one:

  • Loss aversion
  • Present bias
  • Status quo bias
  • Anchoring bias
  • Gambler's fallacy
  • Availability bias
  • Disposition effect
  • Mental accounting

Behavioural bias#1: Loss aversion

You visit your friend over the weekend and strike a conversation with his dad.

"Why should I invest my money in equities when I have an option to put it in fixed-income securities? I can't stomach the volatility of the stock market and I don't want my hard-earned earnings to get wiped away," says Kaushal's dad when you ask him whether he invests in the stock market.

Kaushal's uncle also quips in. "My bank fixed deposits give me peace of mind that they are safe at 5% per annum. It’s not much, but at least it is giving me something. There's no way I want to risk the stock market for high returns. What if I lose it all?"

Kaushal's dad and uncle as some of the many people who are averse to investing in the stock market due to the fear of loss. Even though we've known how equities have historically given good returns in the long run, only a fraction of the people in the country invest in the stock market. And the reason they do so is to avoid the probability of loss.

But isn't fear of loss a valid emotion?

Of course it is. But there is a way to manage this bias.

To benefit from investing in equities, you can choose to abide by certain investment rules that may help you manage the risks. An expert financial advisor can show you how to take calculated risks keeping in mind your financial objectives, time horizon and risk appetite. You can weigh your investment options based on risk and returns of every asset class. And so, this way you can avoid the behavioural bias of loss aversion.

Additional read: Why you need to stay the Course when markets fall

Behavioural bias#2: Present bias

You have been recommended a good financial advisor and you visit his office. As you're waiting, you overhear the following conversation-

Investor: Just look at the way Sona Exports Ltd stocks are rising! I think I should buy them. What do you say?

Advisor: The valuation of that stock is already outstretched. There are better stocks out there. Can I recommend some good ones?

Investor: But I want to look at only rising stocks and I feel that Sona Exports Ltd stocks will only rise higher.

Overhearing this conversation, you wonder many investors choose to take advantage of the current rally, and not consider that it may be risky as they would be buying it at a stretched valuation.

You're absolutely correct.

Some people tend to invest in asset classes that offer good returns in the current circumstances. When they view the equity market performing well, they jump into start investing in the stock market. If they view that real estate or gold is currently giving good returns, they switch from one asset to another.

So how can you ensure that you are not affected by this bias?

The right way to invest is to look into your asset allocation, based on your age, lifestyle, financial goals, income, time horizon, etc. Taking the advice and consultation of a qualified investment advisor can help you make the right choices when it comes to investments and asset allocation. They can help you understand how to take calculated decisions where you can sometime deviate temporarily to take advantage of a specific asset class. But on the whole, remember to return to your original asset allocation percentages. When you keep an eye on your financial goals, you can avoid the lure of short-term payouts that may or may not work in your favour.

Behavioural bias#3: Status quo bias

Your cousin invests only in bank fixed deposits. Recently you met up with him and recommended your investment advisor to help him diversify his investments. The advisor offers a selection of specific equity investments.

So while your cousin is interested in diversifying his investments in equity and aware of the advantages that these investments have to offer, he is unable to take a decision. He postpones making the switch, and now, it's been more than three months that he has still not invested in equities.

When you ask him why, he mentions his lack of confidence and the risk of losing the assurance of safety that the fixed deposits provide him.

 

While this is a common bias among most people, the longer one waits for the right time, the more they may stand to lose. Just like your cousin, several investors do not want to touch their existing investments in traditional securities nor do they wish to discuss the subject.

Why do they do that?

There are several reasons for that. Some reasons behind this behavioural bias could be poor decision-making abilities, lack of confidence and even lack of sound advice.

And how can one overcome this?

To conquer the status quo bias, it is important to review your portfolio regularly and take the right measures after sound analysis and judgment.

Did you know? 

The famous economist, investor, professor and author Benjamin Graham, once said, “The investor’s chief problem—and his worst enemy—is likely to be himself. In the end, how your investments behave is much less important than how you behave.”

Summary

  • The road to building wealth and securing a sound financial future can be through equity investments.
  • Behavioural biases are psychological behaviors that influence your investment decisions and could negatively impact your wealth building opportunities.
  • To conquer loss aversion, you can follow specific investment rules and manage the high risks involved.
  • Seeking the advice and consultation of a qualified investment advisor can help you make the right choices when it comes to investments in asset allocation.
  • Reviewing one's portfolio regularly and taking the right measures of the sound analysis and judgment can help conquer status quo bias.

In the following chapters, we wrap up by busting additional behavioural biases and their influences that can impact your finances.

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