Just remember that creating and managing a portfolio at the level of the fund manager or the investor requires investment decisions to be made on which asset classes to invest in, how to invest, timing of entry and exits and reviewing and rebalancing the portfolio. These decisions have to be based on the analysis of available information so that they reflect the expected performance and risks associated with the investment. Very often the decisions are influenced by behavioural biases in the decision maker, which leads to less than optimal choices being made. Our delivery tips can help you achieve your financial goals in defined time frames.
Some of the well documented biases that are observed in decision making and thus make undertaking investment difficult are as given below:
Optimism or Confidence Bias: Investors cultivate a belief that they have the ability to outperform the market based on some investing successes. Such winners are more often than not short-term in nature and may be the outcome of chance rather than skill. If investors do not recognize the bias, they will continue to make their decisions based on what they feel is right than on objective information
Familiarity Bias: This bias leads investors to choose what they are comfortable with. This may be asset classes they are familiar with, stocks or sectors that they have greater information about and so on. Investors holding an only real estate portfolio or a stock portfolio concentrated in shares of a particular company or sector are demonstrating this bias. It leads to concentrated portfolios that may be unsuitable for the investor’s requirements and feature higher risk of exposure to the preferred investment. Since other opportunities are avoided, the portfolio is likely to be underperforming.
Anchoring: Investors hold on to some information that may no longer be relevant, and make their decisions based on that. New information is labelled as incorrect or irrelevant and ignored in the decision making process. Investors who wait for the ‘right price’ to sell even when new information indicate that the expected price is no longer appropriate , are exhibiting this bias. For example, they may be holding on to losing stocks in expectation of the price regaining levels that are no longer viable given current information, and this impacts the overall portfolio returns.
Loss Aversion: The fear of losses leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure they felt at a gain of a similar magnitude. Investors prefer to do nothing despite information and analysis favouring a particular action that in the mind of the investor may lead to a loss. Holding on to losing stocks, avoiding riskier asset classes like equity when there is a lot of information and discussion going around on market volatility ￼￼￼￼￼￼￼￼￼are manifestations of this bias. In such situations investors tend to frequently evaluate their portfolio’s performance, and any short-term loss seen in the portfolio makes inaction the preferred strategy.
Herd Mentality: This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Such choices may seem right and even be justified by short-term performance, but often lead to bubbles and crashes. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction.
Recency Bias: The impact of recent events on decision making can be very strong. This applies equally to positive and negative experiences. Investors tend to extrapolate the event into the future and expect a repeat. A bear market or a financial crisis lead people to prefer safe assets. Similarly a bull market make people allocate more than what is advised to risky assets. The recent experience overrides analysis in decision making.
Choice Paralysis: The availability of too many options for investment can lead to a situation of not wanting to evaluate and make the decision. Too much of information also leads to a similar outcome on taking action.
We have listed seven biases above that are commonly observed in investment decision making. Professional fund managers have systems and processes in place to reduce or negate the effect of such bias. The checks and balances exist from the stage of gathering information, to interpretation of the information and decision making on entry and exits. Individual investors can also reduce the effect of such biases by adopting a few techniques.
As far as possible the focus should be on data and what it is saying. Setting in place automated and process-oriented investing and reviewing methods can help biases such as inertia and inaction. Facility such as systematic investing helps here. Over evaluation can be avoided by doing reviews to a schedule. Investing strategies such as value investing, which is contrarian in nature; helps avoid the effect of herd mentality. It is always good to have an adviser the investor can trust who will take a more objective view of the investor’s finances in making decisions and will also help prevent biases from creeping in.