Most Indian Investors hope to be well-prepared financially for their retirement and for their future more generally. Some of them give little thought to the details of how they might reach those financial goals and others devote considerable attention to thinking about their investment options. Unfortunately, they do not know that there are instinctive behavioral biases influencing their investments decisions which can affect their investment performance. In order to invest wisely, every investor must know and overcome these instinctive psychological investment patterns that can cloud rational thinking. Because human beings cannot process information as rationally like computers, this problem affects almost all categories of investors, regardless of their age, level of education, gender, etc. Recently, we have observed these types of behavioral problems that can negatively affect your investments. We have also identified their negative effects, which could lead us to making problematic investing decisions.
The idea of anchoring takes place when investors relate to a fixed number, value or stock price as a mental reference point, or “anchor.” Once the fixed anchor point has been created, the investor then focuses on this single value and will tend to hang on to losing investments by waiting for the investment to break even at the price at which it was purchased. Thus, he anchor the value of his investment to the value it once had, and instead of selling it to realize the loss, he takes on greater risk by holding it in the hopes it will go back up to its purchase price.
Sample this: Consider an investment bought for Rs1,000, which rises quickly to Rs1,500. The investor would be tempted to sell it in order to lock-in the profit. In contrast, if the investment dropped to Rs500, the investor would tend to hold it to avoid locking in the loss. Because the number is anchored in his mind as base price of Rs1,000 for the investment and could be a target price and he keeps holding it , year after year, till his investment to be reached again at magical his base price at Rs1,000 even his investment may have no prospect of rising to that level for the foreseeable future. He could sell and make better investment, but he would not do it because the number 1000 is anchored in his mind which must be achieved. The idea of a loss is so painful that people tend to delay recognizing it. Some investors also end up anchoring their investment with the indices as they will sell this stock when the Sensex reaches 25,000 even there is no connection between their investments and the target. When investors are influenced by this pattern, they become stuck and may even ride markets to the bottom if they cannot let go of what they think the price “should” be.
Overconfidence and Investing
When something turns out well after a decision we have made, we claim the credit ourselves. However, when something goes badly, we tend to see this as just bad luck or misfortune. Many investors fall into the trap of believing they can pick winning investments. As a result, they sometimes put too much of their wealth in a single pot, which can be very risky. A savvy investor should understand that picking winning investments is incredibly hard to do, even for professional investors. Investors with too much confidence in their skills often buy and sell too often, which can have a negative effect on their returns. It must be noted that those who buy and sell often were at a disadvantage compared to those who take a long-term view. Hence, investing with overconfidence, this could lead to inappropriate or risky investments and also become an ongoing source of poor decision making.
The problem of inertia
Inertia means that people fail to get around to taking action, often even on things they want or have agreed to do. A related issue is a tendency for emotions to sway you from an agreed course of action – ‘having second thoughts’. The human desire to avoid regret drives these behaviors. Inertia can act as a barrier to effective financial planning, stopping people from saving and making necessary changes to their portfolios. A fundamental uncertainty or confusion about how to proceed lies at the heart of inertia. For example, if an investor is considering making a change to their portfolio, but lacks certainty about the merits of taking action, the investor may decide to choose the most convenient path – “wait and watch”. In this pattern of behavior, so common in many aspects of our daily lives, the tendency to procrastinate dominates financial decisions.
You had seen a car accident on a recent journey and for the next few days, you would drive more carefully because you are likely to overestimate the chances of getting a car accident. To give a financial example, investors are more likely to be fearful of a stock market crash when one has occurred in the recent past. If you think rationally in car accident example, you would observe that the accident personally is irrelevant and being extra careful driving is even more irrational. Likewise, an investor reads a news report about ‘XYZ’ stock or industry or fund and decides to make or avoid an investment into them. There could be many others about whom the newspaper or the analyst chooses not to write on the same stock or industry or fund. Ironically, the same investor missed out that information. We tend to give more importance to information that is available. No one can give importance to information that is not available and we make mistakes in our judgments.
Managing the biases
We have discussed investment behavioral patterns and its implications for investing and financial planning in this article which are thought to be deep-seated aspects of human decision-making processes. Many of them serve us well when making day-to-day choices. But they may be unhelpful in achieving success when thinking about long-term financial decisions such as investing. We are unlikely to find a ‘cure’ for the biases, but if we are aware of them and their effect, we can possibly avoid the major pitfalls.
Latest posts by Suresh Kumar Narula (see all)
- The Secret of Goal-based SIPs? - October 26, 2018
- Do not invest based on returns, rather than goals! - May 18, 2018
- Gold is not bold anymore - April 17, 2018
- Our Planned Trip to Shri Mata Vaishno Devi! - July 17, 2017
- How much should you expect the return? - June 17, 2017