Friday, Dec 01 2023
Source/Contribution by : NJ Publications
Investing should be a logical thing and rational thing. Quite often, long-term investing success is more closely linked to our behaviour and our decision-making framework than anything else. Over the years, this has played the most impactful role in the outcomes. Unfortunately, often emotions and biases play the spoil-sport and influence our decision-making. While emotions can be managed to a certain extent, the biases are more difficult to handle. We may think and believe that we are acting rationally but in reality, even our rational thoughts and decisions are unknowingly influenced by our biases. Thus, it becomes necessary to identify and understand these biases so that we can mitigate their impact on our investment behaviour and our rational decision-making ability.
In this article, we will explore 10 such common personal biases that can impact our decision-making:
1. Illusion of causality:
We have a general tendency to see patterns and connections where none exist, leading us to believe that one event caused another. For example, an investor may believe that past returns will continue to accrue in future because that is how it has been for the past few months. We unknowingly create the bias for or against based on patterns and connections that we create in our minds.
2. Anchoring effect:
The anchoring effect is the tendency to rely too heavily on the first piece of information we receive when making a decision. For example, an investor may come across good news on some investment opportunity and develop a preference for the same despite successive more important negative news. In many ways, we tend to create opinions or judgements based on our first impressions which becomes difficult to change later.
3. Narrative fallacy:
We often fall for stories and narratives and often forget to see if they are supported by proper evidence. In the world of social media, these narratives often shape our opinions on everything, including our investments. Unsolicited ideas and money-making strategies are readily available at the click of a button. In such an age of information, we need to be careful in building and shaping our knowledge based on facts and evidence and not on unverified narratives.
4. Hindsight bias:
The tendency to believe that we could have predicted an event after it has already happened. For example, an investor may exit a market after it has fallen, believing that they should have sold it sooner. Often, we tend to believe that our knowledge and judgement are good after an event has happened even though this may have been for any other reason. Unknowingly, we would become biased on the hindsight of an event happening.
5. Planning fallacy:
We often do a lot of planning for things like buying a mobile or going on a long vacation. However, when it comes to investments, we tend to underestimate the amount of time and resources it will take to do it ourselves. With easy information available, we tend to jump to conclusions very fast and think investing is simple and easy. Unfortunately, it takes time and a few losses to acknowledge our mistakes. Investing needs proper planning, knowledge and expertise and lots of behavioural traits over time to be successful.
6. Loss aversion:
Our bodies and minds have evolved to avoid pain, even the slightest ones. Thus, we tend to feel the pain of losing money more acutely than the pleasure of making money. This can lead investors to make irrational decisions, such as holding onto losing investments too long or selling winning investments too soon. Loss aversion is very common amongst investors and something to look out for to avoid making wrong decisions.
7. Herd instinct:
Again, our minds have evolved to see safety in numbers. We tend to follow the crowd, even when it is not in our best interest. We feel that the majority is unlikely to be wrong and even if everyone is wrong, I will not be alone. We see this repeating often in how the market behaves during different boom and bust cycles and the surprising number of new investors falling for this mentality.
8. Confirmation bias:
It is human nature to have the urge to be right and find ways to prove the same. We unknowingly seek out and interpret information in a way that confirms our existing beliefs. We risk ignoring and giving less importance to facts that counter our beliefs and tend to find comfort in what we already know. As investors, we should be open to ideas even if they are against our beliefs, challenge our understanding and accept that our notions and beliefs can be wrong.
9. Overconfidence bias:
Often, new investors after initial success believe that their knowledge is adequate and they are smart enough to play the game. The tendency to overestimate our own knowledge and abilities is the overconfidence bias we have. A parallel can be drawn in the case of driving too, where almost 90% of people would believe that they are better than average drivers. With this bias, there is a risk that we make decisions prematurely or without adequate research trusting more in our own abilities.
10. Familiarity bias: We tend to find comfort with what we know and there is a tendency to prefer things that are familiar to us. We tend to avoid unfamiliar or unchartered avenues. We can see this with the older generation who are generally risk-averse and prefer to invest in traditional avenues. With this bias, we may risk neglecting and not learning enough of the opportunities out there and staying stuck with sub-optimal choices in investing.
How to mitigate the impact of personal biases on your investments:
Now that we know about the biases we can have in investing, the question is what to do next? Well, there are a number of things that investors can do to mitigate the impact of personal biases on their investments. The first and foremost is to educate ourselves about personal biases. The more we know about personal biases, the better equipped we will be to identify and mitigate their impact on our investment decisions. Being open, flexible and with a bit of introspection, we can overcome a lot of biases.
Next is to create an investment plan and stick to it. An investment plan can help you to avoid making impulsive decisions based on your emotions or biases. As investors, we should focus on learning and keeping an open mind to ideas for a long journey towards financial well-being in life. We should be smart enough to avoid noise and filter information after judging and validating information from diverse sources. Lastly, it is recommended that we also get professional or expert advice. They can extend a holding hand in managing our emotions and our biases in our investment decisions. By understanding and mitigating the impact of personal biases, investors can make more informed and rational investment decisions.
