Jyoti Mehndiratta Kappal
“Everyone was buying the stock, so I also thought of buying some.”
“Last I read the company is doing lot of work in a village. I like to invest in such companies.”
“I knew it. This news will impact the market, therefore I put in some money in the market last week.”
Do the above statements sound familiar?
These are nothing but emotions in play when taking investment decisions.
When an individual decides to invest in various investment instruments, the decisions are not always rational. Other than financial knowledge, factors like personality of the investor, his/her previous experience, experience of friends, and investment behaviour of parents play an important role.
Since 1980 some extraordinary work has happened in the field where researchers have tried to explain the irrational behaviour of investors. Hersh Sherfin in his book ‘ Beyond greed and fear: Understanding Behavioural Finance and the Psychology of Investing’ argued that investors become optimistic as they weighed positive aspects of past events with inappropriate emphasis relative to negative events.
Kahneman & Tversky, critiqued the Expected Utility Theory and developed an alternate model, Prospect Theory. This was a major development in the field of Behavioural Finance where the researchers found that under uncertainty, human decisions deviate from standard economic theory.
Behavioural Finance studies and interprets conduct of individual investors which leads to outcomes in the market. In real life scenarios decisions are not taken rationally, there are various other factors that influence the outcome. When individuals make decisions then they are influenced by market sentiment as well as their personality type. It is of great interest to find out why investors behave the way they do. These deviations are called biases which affects the investment decision making and performance of an individual’s portfolio.
Investors are prejudiced by various biases when they take investment decisions. Underatnding these biases helps the individuals to correct their behaviour which leads to better investment choices. They are broadly classified in two categories: Cognitive and Emotional Biases.
In this two part series we discuss these two classes of biases. In the first part we discuss the emotional biases exhibited by investors and in the second part we will talk of various cognitive biases which impact investment decision making in individual investors.
- Emotional Biases:
The deviations from expected financial behaviour which can be attributed to judgment based on emotions are classified as Emotional Biases. Following are the emotional biases exhibited by investors:
i) Endowment Bias
Investors weigh the loss of parting with an asset more than the gain of adding a new asset to their portfolio. This behaviour is exhibited for both inherited securities and purchased securities. Thus an investors with this bias have desire for familiarity and will not sell securities so as to avoid commission cost.
ii) Self-Control Bias
Generally people display lack of self-control when it comes to money matters. Self-Control is the behaviour to consume today rather than saving for tomorrow. Individuals rationally should save throughout their earning life to have a financially secured retired life (future) but due to self-control bias most of the investors fail to plan for retirement. Such investors also do not have a well-diversified portfolio. Lack of planning (self-control) results in inappropriate preparedness for retirement as people do not want to forego comforts of present to save for needs of tomorrow. As a result of this bias investors do not leverage the benefits of compounding of interest and thus have less financial satisfaction.
iii) Optimism Bias
As basic humans we feel that nothing bad will happen to us. On same lines investors also believe that bad investments will not happen to them. Investors are not able to disassociate themselves and have an outsiders view to the investments that they make, they also tend to suffer from home bias and make investments in companies which are located closer geographically to the investors location. These might always not be sound and rational decisions. This leads to a skewed portfolio which again will impact the financial satisfaction the individual investor.
iv) Loss Aversion Bias
When a investment in the portfolio is not performing, then you tend to hold onto the investment in anticipation of profits, then you are getting influenced by loss version bias.
Investors tend to sell the winning investments in haste lest the market turns around, it results in suboptimal portfolios. These investors are not able to take the decision to exit a loss making investment which leads to a not meeting the long-term goals of the investor and the portfolio.
v) Regret Aversion Bias
The pain of a loss or missing a profit due to poor decision is so strong that investors do not take the decision. This leads to underperformance in the long run thus leading to jeopardising future goals. This might also result in herding behaviour (buying a scrip only because everyone else is buying).
vi) Status Quo Bias
People are intuitively averse to change and like the status quo, thus the status quo bias. Investors will continue with investment which extends their status quo. Status quo and loss aversion together stop the investor from selling a loss making investment thus leading to jeopardising the realisation of long term goals. Which in turn leads to inappropriate preparedness for retirement.
This is continuation of our investigation on biases that impact an individual investor’s financial decision making. In this second and final part we discuss the cognitive biases that influence the decisions to buy, hold or sell an investment instrument.
2. Cognitive Bias
Cognitive Biases are the biases that originate from faulty reasoning. These are the deviations that are a consequence of time, memory and attention limitations. Following are the various cognitive biases:
i) Overconfidence Bias
WE all have met people who feel they know better than everyone else, even the experts. These are people who are overconfident. Overconfident investors overestimate their ability and thus do not pay heed to any negative information on a stock. They are unable to assess their downside risk and thus trade excessively resulting into poor portfolio performance. They may even trade when the true gains are negative which results in an undiversified portfolio. Overconfidence may also lead to inappropriate future financial planning thus effecting long-term financial wellbeing. Also investor tend to be overconfident in their early years as trader, over a period they become more realistic and overconfidence settles down. Infact investors who are highly educated and who do not have high knowledge are the ones who are more susceptible to overconfidence bias.
ii) Representativeness Bias
An individual whenever he comes across new information tries to understand it according to his existing beliefs which might lead to incorrect understanding of the situation/element. Investors suffer from this bias as they tend to categorize a stock with a similar venture , they do not correctly estimate the sample size and thus take small sample as representative of the population .
iii) Anchoring and Adjustment Bias
Anchoring Bias is the tendency to mark a number even if that number has no relevance. Investors tend to give a value to a stock /investment and then they are unable to revise the value even when new information comes to light which indicates future change in value. Thus they keep holding the stock and refuse to look at the new information. This act might be detrimental to their long term financial goals.
iv) Availability Bias
Investors easily relate to outcome which is more prevalent or familiar as opposed to statistically more probable outcome. Availability bias may be in form of retrievability (the most advertised fund is the best fund), categorization (people categorize information that matches a certain preference), narrow range of experience (people tend to work from their restrictive frame of reference) and resonance (an individual’s personal preferences/situations influence his/her judgement). Investors tend to buy stock which are more in news or they tend to buy mutual funds which are more advertised or have their favourite person has the brand ambassador. Again investment decisions influenced by this bias might not be completely rational.
v) Self-Attribution Bias:
When people succeed they tend to take all credit and when they fail they blame external factors. It is best explained by the adage “Don’t confuse brains with a bull market.”. If an investor gains on the stock market then he feels his hard word is responsible for this success. The investor then becomes overconfident. Such investors tend to hold undiversified portfolio and they tend to hear what they want to hear.
vi) Mental Accounting Bias
“This fixed deposit is for holiday and the other one is for the education”. WE all do this compartmentalisation of money. WE put money in different buckets on the basis its source of it or a planned expense and thus tend to view it differently. This is mental accounting bias. It results in investors clinging onto previously gainful investments which are now deflated. It leads to irrational decision making which might impact the portfolio adversely in the long run.
vii) Recency Bias
Investors who exhibit this bias, when they take their investment decisions based on the recent news rather than taking a holistic view of the situation. They tend to ignore the fundamental values and give more emphasis to the latest information. It leading to improper asset allocation.
Awareness of these biases can help investors in understanding their behaviour. Investors can take appropriate corrective actions when they feel that they are getting influenced by one or multiple biases. This will further help them to take sound investment decisions which leads to better portfolios. A better portfolio which help them achieve the final destination in their investment journey which is preparedness for future and financial satisfaction.
Jyoti Mehndiratta Kappal is Associate Professor, Symbiosis International Deemed University, Pune.