Psychological Biases Investors Should Avoid While Buying Stocks
Economics assumes that human behaviour is rational and human being are rational creatures who do things that are beneficial for them. However, this is far from reality, and humans have the highest potential of acting out and behaving irrationally.
Investors, like every other human being, are not immune to this irrationality trait and are subjected to emotions and biases which often influence their investment decisions. While controlling biased and emotions takes time to control, it is essential for investors to control these emotions and biases while making an investment decision. Some of the biases can tempt investors to make unwise investment decisions and lose their investments.
- Anchoring
This implies the tendency to anchor or stick around our thoughts at the point of reference. It can be a completely irrelevant value or a number which might have been stuck in our heads telling us what can be done and what cannot be done. For instance, the stock was trading at Rs. 1200 and crashed to Rs. 800 following a warning issued by SEBI. As the investor is anchored to the price of Rs. 1200, the price of Rs. 800 which appear attractive, cheap and investable. This might tempt the investor in investing in the stock which hopes of the share price rising near to Rs. 1200 but the probability of the stock price falling further impending a further SEBI investigation can lead to the investor losing their investment.
This is similar to a salesman trying to upsell a cheaper related product when a customer is buying an expensive product. Since the cost of the expensive product, let’s say as Rs. 10000 Nike sports shoes, appears much cheaper than socks costing Rs. 899. Due to this price of Rs. 10000 being anchored in the mind of the customer, the customer might find the cost of the socks inexpensive and might end up spending more than they initially had planned and anticipated.
- Mental Accounting
This is known as a tendency of dividing your money and maintaining them in separate bank accounts by a wide array of subjective criteria. This can apply to the source of income and the expenses and investments it is assigned towards. These tendencies can allow bankers to convince their clients to borrow money to buy a new car even though they have ample liquidity in their bank accounts. This form of mental accounting can also influence an investor to assign different functions to every asset group and investments, as a result of this making their investment decisions irrational, ineffective and inefficient.
Another factor of mental accounting which can ruin investment decisions is not understanding the concept of compound interest or how beneficial a 12% CAGR can be more beneficial to the investor’s portfolio for 15 years instead of 5-years. Not understanding the power of compounding is some of the behaviour traits which can make a person happy when they receive an income tax refund without thinking about the fact that they have paid too much in advance tax.
- Overconfidence Bias
Investors can at times overestimate the value of certain items or their ability to do certain things. For instance, women might overestimate their cooking skills while men can overestimate their investment skills, even though there is no academic studies or empirical evidence supporting these claims. Investors can develop tendencies of over-confidence due to reasons such as their experience in investing, their past success etc. and develop a false sense of over-confidence regarding their ability to predict stock price movements etc. These traits and tendencies can encourage investors making irrational investment decisions and incur losses on their investments.
- Loss Aversion
The tendency of loss aversion can change the point of view of an investor, forcing them to make irrational investment decisions. For instance, an investor has invested a total of Rs. 6 lakhs in stocks A and B, wherein the investor has invested Rs. 4 Lakhs in stock A and Rs. 2 lakhs in stock B. After a few months, the value of stock A has fallen to Rs. 3 lakhs and the value of stock B has increased to Rs. 3 lakhs.
Now in a scenario, when the investor is in need to Rs. 3 lakhs, which stock will the investor sell? The loss aversion bias in an investor will tempt the investor to sell stock A to avoid further losses, whereas smart and rational investor, will analyse the growth potential of both the stocks and accordingly take a decision to liquidate their investment.
- Hindsight bias
An investor tends to feel that they could have predicted an event after it has taken place. The fact remains that one cannot predict future events, but such hindsight bias can cloud the judgement of an investor and tempt them into making an unwise investment decision. For instance, when the international prices of crude oil had crossed $ 130, no one could have predicted that it would fall to $40, but it did within a time of two-years. Investors see things only after an event has taken place but feel they could have predicted the event and make their future investment decisions based upon their hindsight biased and end up making unwise investment decisions.
- The Gambler’s Fallacy
Investors often invest in penny stocks assuming they can quickly flip their investment and make attractive returns on their investment while letting opportunities of investing in credible and profitable stocks pass by. Another gamble investors love taking is IPOs. There is a gambler’s fallacy among investors that subscribing to an IPO would give them attractive returns on the launch date itself, but that not be the case. For instance, the Reliance Energy IPO has to date not touched its issue price since its launch, as a result of this the investors who had subscribed to the IPO lost their investment.
- Herd Behaviour
One of the biggest factor influencing the investment decision of a large number of investors in the country is following a herd behaviour and following the bandwagon. Such investors invest in a certain stock only because their friend has invested in the stock, or they have read a news report stating high buying movement of a certain stock. It should be understood that the investor generally investing in stock due to herd behaviour is probably investing too late, and the stock has already peaked; hereby the investor does not make any returns on their investments.
Closing Thoughts
People are pre-programmed with biased behavior as it is a part of human nature, and it can be difficult to separate biased behaviour and rational behaviour for many people. But investors need to understand that investment in the stock market has no room for biases and emotions, and investment decisions need to be made using rational research rather than jumping onto conclusions. If you have this question Why do we need investment advsiors read this blog.
Being able to differentiate biased nature with credible market information is what separates a great investor from a regular investor.