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Jan 13, 2018 11:27 AM IST | Source: Moneycontrol.com

Want to become a crorepati by investing in markets? Avoid these investing biases

One of the most common biases is the effect of perceived or actual loss. As humans, our emotional response to perceived losses is different than to that of perceived gains. Numerous studies have found that losses for an investor feel twice as painful as gains feel good.

Moneycontrol News @moneycontrolcom

By Deepak Jasani

Investing in equity markets is as much a product of the temperament of the investors and their psychology as it is of a detailed study of a company and assessment of its valuation.

We tend to focus more on and anticipate the external events, on which we have limited or no control than properly understanding our own investing style and the boundaries of our knowledge.

This gap in this understanding manifests itself in the form of psychological biases which affects how the person goes about with his investments.

One of the most common biases is the effect of perceived or actual loss. As humans, our emotional response to perceived losses is different than to that of perceived gains. Numerous studies have found that losses for an investor feel twice as painful as gains feel good.

While incurring a certain amount of losses is an inevitable part of investing (as inevitable as earning profits), investors are reluctant to sell their loss-making investments to avoid confronting the fact that they have made poor decisions.

Investors also suffer from confirmation bias, which makes them selectively filter data, paying more attention to information that supports their opinions while ignoring the rest.

An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her original idea about an investment rather than seeks out information that contradicts it.

Another common perception bias is hindsight bias, which leads an investor to believe after the fact that the onset of a past event was predictable and completely obvious whereas, in fact, the event could not have been reasonably predicted.

This has undesirable consequences like making the investor falsely believe that he can easily predict future events or lead the investors to lament about missed opportunities and making them feel dejected.

More often than not, investors tend to attribute successful outcomes to their own actions and bad outcomes to external factors. This is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy.

They often exhibit this bias as a means of self-protection or self-enhancement. Investors affected by self-attribution bias are almost always overconfident, which can be very dangerous while investing in equity markets.

Some investors, however, suffer from the opposite of overconfidence and over-optimism. Charles T Munger of Berkshire Hathaway summarized this as follows: “You have to strike the right balance between competency or knowledge on the one hand and gumption on the other. Too much competency and no gumption is no good. And if you don’t know your circle of competence, then too much gumption will get you killed.”

Chasing past performance in the mistaken belief that historical returns predict future investment performance is another common fallacy.

This tendency is complicated by the fact that some product issuers may increase advertising when past performance is high to attract new investors. Research demonstrates, however, that investors do not benefit because performance usually fails to persist in the future and reverts to the mean.

Investors also suffer from planning fallacy which is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.

It’s at least partly why investors underestimate bad results and think it won’t take them as long to accomplish something as it does.

With so many reports and “stories” about various stocks floating around in financial media, investors get easily distracted. They inherently prefer narrative to data — often to the detriment of their understanding.

Keeping one’s analysis and interpretation of the data reasonably objective – since analysis and interpretation are required for data to be actionable – is really hard even in the best of circumstances and it becomes even more difficult when the investor is surrounded by such irrelevant noise.

We as humans are prone to recency bias, meaning that we tend to extrapolate recent events into the future indefinitely or give a lot more importance to recent events and fail to include evidence covering a sufficient time period before we make our decisions.

While in our personal life we may judge a person on the basis of his most recent behavior while investing we may give too much importance to the most recent performance. Chasing the top performer of the year or dumping an existing stock/MF scheme on the basis of recent underperformance are the outcomes of this recency bias.

Many a time it happens that an investor misses the opportunity to buy a stock because its price “runs away” before he/she could buy it. In that case, the investor waits for the stock price to come down to that level, believing that it will.

However, this belief is not always based on facts or circumstances of the run-up in the price. There is a good possibility that the stock might not return to the original price for a long time or perhaps forever.

These biases prevent the investor from achieving the ideal returns. He has to work upon his thought process, emotional responses, temperament etc. so that he can at least conquer some of them so that he ends up being an evolved rational investor and makes the ideal returns from his investments.

Disclaimer: The author is Head – Retail Research, HDFC Securities. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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