Investing is not always a logical decision, the mind has its own bias

Let us look at some practical examples about how your mind may trick you into falling trap to various psychological biases.

Sunk Cost Fallacy:

Suppose you have put your entire money in 2 stocks. Stock A and B. Today stock A is in 30% profit and stock B is in 10% loss.

You need some funds urgently which requires you to sell any 1 stock.

Which one would you sell? The common answer is stock A.

Acquisition prices or the prices that you bought at don’t matter. It’s the future expected performance (and performance of alternative options) that matters. The psychological pain while booking losses is much higher than booking profits so, the instinctive answer in most cases is selling stock A.

Stock A may be the better option to hold as it is making a profit and may continue to do so. Stock B on the other hand will need to go up by 44% just to match the level stock A is at.

Survivorship Bias:

“I invested in XYZ stock 10 years ago and it is a multi-bagger today” -- This is a common statement that one may have come across when a stock market discussion sparks up. If an investment survives a 10-year time frame it is likely to make a good cumulative profit. However, what about the bets that did not work well?

Over the past 10+ years, out of 923 unique stocks that were a part of the Nifty 500 Index at some point, 422 stocks are no more part of it.

The Nifty 500 Index has gone up by 342% but the weaker stocks are no more a part of it today because, when the market cap reduces or due to corporate actions, some stocks move out of the Index. As a result, the surviving cohort seems to have done comparatively well.

What matters is the money made on the overall portfolio and not on individual stock bets. 

Scarcity Error:

NFTs were the talk of the market in 2020 and 2021 when money was cheap (low interest rates). The selling point of NFTs was that they are uniquely identifiable, cannot be copied, substituted or subdivided.

This scarcity effect of NFTs drove the prices high as creators started artificially creating demand. But since 2021 sales have plummeted as creators have flooded the market with different types of NFTs.

A similar effect is also seen in IPOs where investors are attracted to a certain company only because it is oversubscribed.

By creating a sense of urgency and scarcity some investments may appear more attractive than they actually are. 

In situations where the stakes are high, intuition could affect decision making. If several such decisions are taken over a long period, it could significantly affect your investment portfolio.

What steps can an investor take to reduce these biases?

1. Having a rule-based exit strategy could help minimize the sunk cost fallacy effect. Another solution is to find a comparable investment with better prospects and transfer the money from the loss-making investment to the comparatively better substitute to reduce the psychological effect of booking a loss.

2. While analysing an investment strategy, rather than focusing only on the winning stocks, study the traits present in those that have made loses to reduce the effect of survivorship bias. Avoiding red flags is as important as finding new opportunities.

3. To reduce the scarcity error, list down 3 things that could go wrong if the scarcity aspect of an investment was not present. Also strictly limit the bet size of such investments to less than 5% of your overall investments.

To keep things simple, in situations where the possible consequences are large, be as reasonable as possible. List down the biases that are likely to occur and apply the hard, slow, and rational thinking. In situations where the consequences are small or you are in your circle of competence, let your intuition take over.