Avoid these behavioural biases while investing in volatile markets

Everybody says that discipline is the cornerstone of a successful investment strategy. Whether you are a newbie or a veteran investor, you won’t make serious money unless you have discipline. But along with sticking to time-tested investing rules, you also need to maintain emotional discipline. The biggest money mistakes are committed when individuals let their emotions dictate their investment decisions.

Driven by behavioural biases, investors often end up making illogical and irrational decisions that are based more on perceptions rather than factual analysis. Greed and overconfidence take over when markets rally and become overvalued. On the other hand, investors get overwhelmed by fear and doubt when stock prices are low during a bear phase. Let us examine some of the behavioural biases that may hurt your finances and how you can overcome them.

Confirmation bias: Investors look for validation of their decisions and therefore search for information or news to confirm their beliefs. But in doing so, they often tend to pay more attention to the opinions and information that support their line of thinking. Any information or analysis that contradicts their thinking is given less importance or even ignored completely. Cherry picking of information that validates your own views can be dangerous, especially in an overvalued market that does not have the fundamentals to support stratospheric levels. Instead of letting their preconceived notions determine their investing decisions, individuals should carefully sieve the information they get and act accordingly.

Overconfidence: This is one of the biggest impediments to successful investing. Initial success in stocks can make an investor overconfident about his ability to spot winning scrips, even though the real reason could be sheer luck. If their stocks have done exceptionally well, an investor starts thinking that he is in control and may amplify his investments, often putting more in stocks than he can afford to lose. It can also lead him to start trading too much, which is likely to be less profitable in the long run. Studies have shown that holding the right stocks for long periods earns higher returns than continuously churning the portfolio. In any case, too much trading indicates a tendency to time the market, which is always a zero sum game for the average retail investor.

Recency bias: Human beings tend to have short-term memories and investors even more so. They tend to get influenced by recent events more than other events back in time. It is the same attitude that makes investors choose mutual fund schemes based on their recent performance in the mistaken belief that they will continue to churn out recent stellar returns. Adding to the problem is the product promotion done by financial services companies. To attract new investors, a mutual fund or insurance company will advertise a scheme or fund when its recent performance has been very good. However, research shows that mutual fund winners keep changing and the good performances usually fail the sustainability test. This bias is quite evident in the surge of new investors who have entered the stock markets in the past 1-2 years.

Anchoring bias: Investors tend to mentally assign levels to their investments. If a stock they hold runs up very fast, an investor will want to book profits even though the share may have the potential to rise further. This anchoring to the buying price leads to winning stocks getting sold off early. A lot of investors offloaded Maruti Udyog shares when they opened 32 per cent higher than the issue price of Rs 125 in 2003. The stock eventually rose to Rs 10,000 in 2018, a gain of nearly 8000 per cent in 14 years. On the other hand, investors hold on to losing stocks in the hope that they will recover. Reliance Communication and Reliance Power are prime examples of stocks held by investors who are anchored to the buying price, hoping for the shares to regain their former glory.

One way investors can get over these behavioural biases is by taking the help of a qualified investment advisor. A financial planner can take the emotion out of investing by creating an investment plan based on the financial goals of the individual. Another way can be automating investments by starting monthly SIPs or by investing in dynamic asset allocation funds. These funds continuously change the asset allocation of the portfolio based on market valuation. When valuations are expensive, they will reduce equity exposure to cut the risk. When valuations are cheap, they will increase the equity exposure to gain from any bounce-back.

Investing should always be a cool and calculated affair and should be maintained over longer periods of time – it will be time and energy very well-spent.

(The writer is Managing Director, MyMoneyMantra.com)