When we talk of an investor, we relate him to only money and finances and tend to overlook the fact that first, he is a human being and thereafter an investor. Investor behaviour is characterized by his feelings, moods and sentiments, personality traits, perception, attitude and emotions. Therefore, like all other humans, his actions and decisions are affected by various biases. Investor psychology (the science dealing with the mind and mental processes, especially in relation to investor behaviour) classifies these into heuristic biases and cognitive biases. Simply put, a heuristic is a ‘Rule of Thumb’ mental shortcut used to solve a problem. It is a quick, informal, and intuitive algorithm that the brain uses to generate an approximate answer to a reasoning question. When investor heuristics fail to produce a correct judgment, it can sometimes result in a cognitive bias, wherein the processes information by filtering it through his experience, thoughts, likes, and dislikes. Psychologically, these biases lead an investor to a judgmental error when it comes to investing, which includes both buying and selling of the financial instruments. In this article, we will explain how some of these or other biases play up to influence the investor’s decision making. Some of these biases are listed in the chart below, and explained and exemplified through Mr Anil, a retail investor residing in a Tier II city of India, in the succeeding paragraphs. He represents the common salaried man who has two children and strives to make his ends meet within his salary.
Present Bias: This is the tendency to overvalue immediate rewards at the expense of long-term goals. This bias propels Anil to live in the present without thinking too much about how the future unfolds. This gives rise to the tendency of overspending or anticipating a future windfall, which creates barriers to current saving and hampers long-term investment. Therefore, he indulges in buying consumer durables and enjoying lavish vacations and parties and postpones saving for his retirement to a later date. This proves disastrous in the long run since Anil does not start investing early. Thereby, he loses the advantage of the exponential growth of his early investment into a sizeable retirement corpus achieved through the power of compounding, which requires time.
Representativeness: This refers to the tendency to form judgements based on stereotypes. For example, you may form an opinion that a person is rich if you see him alighting from a luxury car, even when he does not own it but has merely travelled in it as a guest of the owner. This results in investors labelling an investment as good or bad based on its recent performance. As per Chandra Prasanna (2016), Behavioral Finance, McGraw Hill Education, investors may be drawn to mutual funds with a good track record because such funds are believed to be representative of well-performing funds. They may forget that even unskilled managers can earn high returns by chance. Investors may become overly optimistic about past winners and overly pessimistic about past losers. Investors generally assume that good companies are good stocks, although the opposite holds true most of the time. Consequently, Anil may buy stocks after prices have risen expecting those increases to continue and ignore stocks when their prices are below their intrinsic values.
Availability Bias: It is a bias where most relevant, recent, or traumatic events strongly influence the perceptions of investors that may be far from economic reality. The danger of basing investment decisions on market perception, rather than facts, is that Anil may pull his money out at the wrong time and miss some of the best days as the market recovers. In the stock trading area, this bias manifests itself for Anil through his preference to invest in local companies, which he is familiar with or about which he can easily obtain information, rather than relying on deeper market research.
Anchoring: It is the tendency to hold on to a belief and then apply it as a subjective reference point for making future judgments. Anchoring occurs when an individual lets a specific piece of information control his cognitive decision-making process. As per Chandra Prasanna (2016), Behavioral Finance, McGraw Hill Education, there are two plausible explanations for anchoring. The first is based on uncertainty relating to true value. When there is uncertainty, the decision maker adjusts his answer away from anchoring value until he enters a plausible range. This explanation works best for relevant anchors. The second explanation is based on cognitive laziness. Since it requires effort to move away from the anchor and people are cognitively lazy, they tend to stop too early. This explanation works best for irrelevant anchors. Therefore, anchoring will lead Anil to invest in the stocks of companies that have dropped considerably over a short span of time. He is likely anchoring on a recent high point for the stock’s value, likely believing in some way that the fall in price suggests that there is an opportunity to buy the stock at a discounted rate. As far as Anil is concerned, the overall market has caused some stocks to drop significantly in value, thereby allowing him to capitalize on short-term volatility. However, what is perhaps more likely is that a stock which has dropped in value in this way has seen a change in its underlying fundamentals.
Regret or Loss Aversion: This refers to an important concept encapsulated in the expression “losses loom larger than gains” as the pain of losing is psychologically about twice as powerful as the pleasure of gaining. Typically, this is noticeable in the game of golf where the golfer avoids a water hazard by going around it or taking a layup shot. In the bargain, he loses a stroke or is required to play an excellent shot thereafter to make up the loss. Similarly, Anil will prefer to avoid the loss because the associated pain is more intense than the reward that he will feel from a gain. To avoid this pain of loss, he will try to play safe and resultantly move his investments to a place he perceives as safe-haven i.e. cash, cash equivalents or fixed income instruments. Another step he may undertake is to discontinue his ongoing SIP/SEP. All this will cost him when the inflation eats into his savings and erodes his purchasing power. Regret aversion can explain investor reluctance to sell losing investments because it gives them feedback that they have made bad decisions. Anticipated regret influences Anil’s decision making to take less risk because this lessens the potential of poor outcomes.
Overconfidence: This bias leads to the false assumption that someone is better than others, due to their own false sense of skill, talent, or self-belief. Investors often exhibit overconfident behaviour resulting in severe consequences. Research documents that overconfident behaviour is connected to excessive trading and results in poor investment returns. It can also lead to investors failing to appropriately diversify their portfolios. Overconfidence plays out in the real world and creates biases, viz. over ranking, illusion of control, desirability effect and timing optimism. Therefore, Anil having performed well in recent past may conclude that he is truly skilled and take more risks and trade more. To him his overconfidence will make future trades look less risky, but, when things go wrong his potential losses will be higher as they are directly proportional to his degree of overconfidence. Barber and Odean (2001) studied the role of trading behaviour and gender bias for a sample of 35,000 individual accounts over a six-year period. Their findings reveal that males are not only more overconfident about their investing abilities but also trade more often than females. Compared to women, men also tend to sell their stocks at the incorrect time resulting in higher trading costs. Women generally trade less and apply a “buy and hold” approach resulting in lower trading costs. Other studies have found that the relatively young are more overconfident than the relatively old and that highly overconfident people tend to have a higher risk tolerance.
Herd Effect: It happens when people feel most comfortable following the crowd and tend to assume the consensus view to be the correct one. It is also referred to as the bandwagon effect where the phenomenon of a popular trend attracts even greater popularity. This is the single most important bias in financial markets that create economic bubbles, which burst later to erode capital of the investors. History is replete with example of such bubbles, where during the run-up, investors bid up the prices to unsustainable levels. Then, even more quickly than they expanded, these markets burst and contracted to leave the herd scrambling. It is because of this bias that Anil will invest into a scrip or financial instrument that forms part of the rising bubble without due diligence and personal research, only to lose his capital when the bubble bursts.