Behavioral Biases

I always thought and will always believe that investments are and will always remain an eclectic field. It is not restricted to ideas from the field of commerce, and that's what magnifies its beauty. Various ideas can be borrowed and successfully applied to the investment world, which can help you get the kind of return you want. One such field that has an overwhelming effect on your investments is psychology. In fact, the importance of psychology is such that when I asked an investor what I needed to understand prior to stepping into the investment world, to my surprise, he said commodities and psychology. 4 Years into the journey and I can't stop stressing upon the importance of psychology. 

Psychology is the protagonist that fuels the bull markets and creates bubbles like the tuple mania from 1673 or the recent Adani frenzy in 2020. It is also the protagonist that caused the Y2K fall or the 2008 crash. Believe it or not, psychology does give a rational and unemotional investor an opportunity to buy when the markets are licking the floors and an opportunity to sell when the markets are at an all-time high. The highlight of this statement is being rational and unemotional. Aligning your psychology with the way you trade and invest can make you as rich as Scrooge McDuck. Even though we are not going to discuss individual psychology, we are surely going to discuss a few biases that are funny yet can cause one of us to make irrational decisions. So, to save yourself from future financial embarrassment, let me share some of the psychological biases that can help you invest better. 

1. CONFIRMATION BIAS: This is one of the most common biases that we will find in the markets. It is basically a tendency to search for reasons and information that confirms one's belief or hypotheses. It mostly happens when a trade is holding on to a loss position, when a trader takes a position for a reason and that reason doesn't work out, then such traders look for more reasons to justify his positions so that he can hold on to the loss-making position. This below picture explains the situation quite well. If we extent this bias, it also gives rise to In-group bias. It is a tendency where we surround ourselves with those who share the similar takes on our outlook. This kind of gives us a false sense of security and also makes us angry on outsiders who dare to question how we feel. 

                                       

2. LOSS AVERSION BIAS: Loss aversion refers to the investor's tendency to strongly prefer avoiding losses to acquiring gains. The fear of loss leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure of gain of similar magnitude. Investors prefer to do nothing despite information and analysis favoring a particular action that in the minds 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 is manifesting on 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 their preferred action.  

3. OWNERSHIP BIAS: Things owned by us appear most valuable to us. Somewhat known as the endowment effect, it reflects the tendency to place a higher value on a position that others would themselves not but at the current levels. This commonly leads to selling a stock even when all the indicators suggest that such stock should be sold.

4. GAMBLERS'S FALLACY: Predicting absolutely random events on the basis of what happened in the past or making trends when there exists none. It is the mistaken belief that if something happens more frequently than normal, then it will happen less frequently in the future, or that if something happens less frequently than normal during some period, then it will happen more frequently in the future. It is very visible in the Indian stock market also - the lenders who were leading the 2008 rally are now in the junkyards and people who fell for such bias are setting on heavy losses. It will be the eighth wonder if the likes of DLF, Unitech etc. see their 2008 peaks again. 

5. WINNER'S CURSE: Tendency to make sure that a competitive bid is won even after overpaying for the asset. While behaviorally it is a win, financially it may be a loss. It is basically overestimating the value of goods and then ending up worse off than the losers. It is more linked with errors of judgement. The winner's curse says that in such an auction, the winner will tend to overpay. The winner may overpay or be "cursed" in one of the two ways: the winning bid exceeds the value of the auctioned assets, such that the winner is worse off in absolute terms; or the value of the asset is less than the bidder anticipated, so bidder may still have a net gain but will be worse off than anticipated. 

6. HERD MENTALITY: This 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 leads 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 a correction Most of the individuals don't go against the crowd as economist John Maynard Keynes said: "it is better for reputation to fail conventionally that to succeed unconventionally". Most of the retail traders end up losing money in the markets because they enter at the stage of euphoria when the markets are over heated, and they tend to follow the herd mentality. 

7. ANCHORING BIAS: Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered when making investment decisions. Investors hold onto some information that may no longer be relevant, and makes their decision 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 indicates that the expected price is no longer appropriate, are exhibiting this bias. 

8. PROJECTION BIAS: We project recent past to the distant future completely ignoring the distant past. IF we can avoid the above biases, we well might become masters of our own mind and the most beautiful thing that was ever invented, money.