Successful investing is nothing but being a master of one’s own emotions. One of my favourite quotes is by Peter Lynch: “Success depends on the ability to ignore the worries of the world, long enough to allow your stocks to compound”. Unfortunately, the world around us constantly batters us with noise and news. As a result, the investor is often worried and emotional, ending up making bad decisions. Here is where an understanding of behavioural science-based investing can help an investor navigate the choppy waters of investing.
What is Behavioural Science-Based Investing?
Behavioural science is simply the amalgamation of various subjects such as economics, brain science, human psychology, social studies, and economics, but with a focus on how human beings react under various situations. The most important outcome of this is the understanding of the motivations behind decisions.
Since we operate under various influences, the cross-disciplinary nature of behavioral sciences helps identify them and determine which ones are at play. There are dozens of patterns of such influences, often termed cognitive biases or emotional biases.
Decisions are Important in Behavioural Science Based Investing
Each person makes hundreds of decisions every day and thousands every month. Some may be trivial, but those that involve one’s health, money, and investments have a bigger impact. This is why studying behavioral science enables an investor to understand the reasons behind what motivates them and why they make certain decisions.
It also helps them recognize a bad decision, which can pave the way to make suitable amends. In the stock markets, humility helps one recover from a bad investment and recoup the loss by finding an alternate investment. Hubris, on the other hand, has always taken the big and mighty down. An understanding of Behavioural science-based investing can help us uncover more of these biases.
Common Investor Biases
1. Loss aversion
People are loath to sell stocks that incur losses. It doesn’t matter that exiting a bad stock can enable investing in a better stock. People ignore the much higher opportunity cost, just because they do not want to book the loss.
2. Hindsight bias
People see past events and recent bull runs as long-lasting patterns. They find a market crash as an unpredictable event. Not having the trouble of a prudent asset allocation, they can revisit their decision if the need arises.
3. Confirmation bias
This is simply sticking to one’s beliefs and an overt sense of confidence, often ignoring fresh data. This could be a stock that one feels has always done well and ignoring key risks that emerge around it. In fact, the believer often ignores data that does not ‘conform’ to their thinking. To overcome this, one must be ready to jettison old ideas. Charlie Munger once said: “Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire.”
4. Information bias
This is to overanalyze and consider every piece of information available, resulting in analysis paralysis. They may also jump at bad news and quickly sell off a good stock without looking at the big picture. A good investor is able to see the wood from the trees and sifts information skillfully without getting overwhelmed.
5. Incentive-caused bias
People ignore the power of incentives that middlemen or even some fund managers may have in pushing certain investments. Being aware of this effect helps one evaluate why certain decisions are being made. They prefer to hold investments in products where there is complete transparency. Warren Buffett once said: “Nothing sedates rationality like large doses of effortless money”.
6. Bandwagon effect
Also called herd mentality, this is dangerous and often leads to investors following others without bothering to do any due diligence. Some popular fund managers even publish their investments goading gullible investors to buy them. Unfortunately, the latter are caught napping when the fund manager exits and clears their positions.
7. Anchoring bias
People lock into a certain price and may miss buying a stock just because it is no longer available at the previous price. People who missed Tata Elxsi NSE -0.61 % at 1,000 would be shy of buying at Rs 2,000. Alas for them they still kept watching the stock as it climbed further higher up all the way to 10,000. The key here is to do the research on what are the fair value and future potential of a company rather than naively expecting a set price to hold.
These are just some of the more than 50 investment biases that one can list from literature and the annals of stock market history.
Conclusion
To emerge as a successful investor, one must keep emotions in check without being too fearful, overconfident, or greedy. One must practice effective asset allocation, portfolio diversification, and re-balance regularly. Rebalancing on a regular basis fosters a disciplined attitude to decision-making by enforcing decisions that could be emotionally challenging, but have the potential to be financially advantageous.
It is essential to comprehend and, ideally, overcome typical human cognitive or psychological biases in investing. These frequently result in poor decisions and investment mistakes. Such poor decisions lead to poorer portfolios. Because cognitive biases are wired deep down in our brains, we are all vulnerable to oversimplifying complex judgments, taking shortcuts, and being overconfident. Understanding the basics of behavioural science in investing, and these cognitive biases can lead to better decision-making, which is fundamental to lowering risk and improving investment returns over time.
Authored by Ram Kalyan Medury, Founder & CEO Jama Wealth.
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