Fixing A Freudian Slip In Investment

As humans, it is only natural for us to sway to our emotions. There are days when one feels euphoric because everything goes right— from finding less traffic on the way to a fruitful day at work and so on. Similar euphoria is witnessed amongst investors when the markets are performing well. The study of this, known as behavioural finance is important to understand how and under what circumstances people make certain financial choices. 

It is thought that our investment decisions are taken rationally, but that is not always the case. “In investments also, one tends to make a decision based on fear, greed, optimism, pessimism, outlook, comparisons, herd mentality and many similar emotions,” says Madhupam Krishna, Sebi-registered investment advisor and Chief Business Officer at WealthWisher Financial Planners & Advisors. John R Nofsinger, Author, ‘The Psychology of Investing’ says, “People can be overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks and exaggerate their ability to control events.”

However, it is best not to take investment decisions emotionally. As humans, our fear of loss is stronger, almost double the joy of winning.

It has been seen that in majority of cases, market performance dictates investors’ reaction. As for example, a poor market performance often drives investors into a frenzy, losing every iota of logic.

Let us now take a look at some of the key biases that affect our investment decisions.

The first and most common bias amongst investors is denial. Most of the time, investors do not want to part with their long-held stocks or asset, despite their underperformance. They are in such a state of denial that they become oblivious to the fact that the overall returns of the portfolio is falling due to the said asset.

The next one is, information processing errors, also known as heuristic simplification. In this case, investors use a simplified method to eliminate problems instead of using logical reasoning. Such an approach can be detrimental as crucial informations are being done away with in order to reduce complexity and only part information is accepted. This can lead to flawed decisions, which can be dangerous to the stock market.

However, all these biases stem from a single factor— extreme emotions. Investors, instead of making decisions with an objective mindset, tend to solely respond to their biases. With misconception, misinterpretation and past experiences blocking all logical bents, investment decisions are exposed to possible risk and losses.

The next one - recency effect - refers to a bias that makes people recall and believe only the latest information received, ignoring the older ones while making a decision. For example, many investors resort to close their SIPs when equity markets are down.

Another common bias, which is applicable to the field of investments is herd mentality. This is one of the strongest biases investors face.

“Often in investments, individuals subconsciously follow a group – among peers or a rich celebrity broker featuring on TV. They feel their decisions are based on their own judgment and independent thinking but they are actually just following the herd,” states Krishna.

In fact, investors often fear losing out on profitable oppurtunities if they do not follow the popular demand option.

Another investment bias is loss aversion. The fear of losing something motivates people more than the prospect of gaining something of equal value.

The sunk cost fallacy is also one of the investment biases. It is defined as a cost, incurred in the past that cannot be recovered. But when it comes to investing, people find it difficult to let go of sunk costs and continue to stick to bad investment decisions because they have invested their time and money into it. “This is the main reason why despite being stuck in a wrong investment, one continues with it, as exiting the same would lead to an immediate loss,” says Chenthil Iyer, CEO, Horus Financial Consultant.

Another common bias that we all are guilty of being a victim is instant gratification. Living in the world of everything ‘instant,’ such as noodles and coffee, has made us impatient. People want to get returns very fast. Whereas fruitful results take time as patience plays a major role in it.

“We need to understand the concept of delayed gratification. It means resisting a smaller but more immediate reward for the satisfaction of getting something better and more enduring, later. This will not only help our personal finances but other aspects of life too,” states Krishna.

Mental accounting is another key bias. “This makes people take uncalculated and irrational risks with the money earned through a successful speculative investment. Because of this, investors tend to value such ‘free money’ lower than their ‘hard earned’ money,” says Iyer.

Apart from these there are several other biases that affect our investment decisions. It is important to be aware of them in order to not fall victim to it. “The insights that investors receive from behavioural finance will help them greatly to understand themselves better and be alert to situations where their emotional and psychological predispositions are becoming a hindrance to making optimal financial decisions, which include both spending and investment decisions,” further comments Iyer.

Hence behavioural finance advocates suggest two ways to proper decision-making. They are:

- Reflexive: Your default option of following your gut feeling and inherent belief.

- Reflective: Requiring a deep  thought process, this approach is logical and methodical.

Following the reflexive approach can lead an investor towards biases like herd mentality, heuristic simplification and so on. Therefore, in order to mitigate against it, processes need to be set up.

Advocates of behavioural finance suggest that it is best to create a set  of processes and follow it to a logical  and methodical decision.

anagh.pal@outlookindia.com