Behavioral biases are irrational beliefs that influence behavior and unconsciously impact our decision-making process. Investing decisions are often a result of behavioral biases that make people act on emotions or make errors while processing information. Behavioral finance researchers who study the psychological factors that influence investors’ decisions confirm that investors tend to take mental shortcuts while making complex decisions. These work as escapeways and can bias our judgments whereby we end up making irrational investing decisions. Let us look at six behavioral biases that affect investing decisions along with ways to minimize their influence.
Behavioral Biases In Investing
1. Loss Aversion Bias
When it comes to investing, people are more sensitive to losses than gains. They do not put their money in the investing basket if they believe there is a risk of loss. They are afraid of losses, no matter how minor. This anxiety will prevent individuals from investing, despite the fact that the investment is worthwhile. They choose to save, despite the fact that inflation will erode the value of their savings. However, if you invested in a solid stock and held it for a long time, you may have made a good profit. If you have a lengthy time horizon, a varied portfolio of common stocks may be the best alternative. Due to stock market volatility, however, people prefer low-risk, low-return money market securities.
Avoiding Loss Aversion Bias:
Keep in mind the basic rule of finance: ‘High Risk Equals High Return, and vice versa.’ You will not achieve that reward if you are unwilling to take that risk. You could try to take some risk by investing in assets that have a good track record. Do not allow yourself to become emotionally tied to your investments. Know that risk is an inevitable component of investing, and you can’t always avoid it. It’s a myth that you can always be right when it comes to investing. As a result, it’s only natural for you to book a loss and seek out new investing opportunities.
2. Overconfidence Bias
Overconfidence bias is a tendency to overestimate one’s abilities, knowledge, and capabilities. While confidence is beneficial, overconfidence is detrimental since you are more likely to make poor decisions when you are overconfident in yourself and your knowledge. People have an excessive amount of faith in the quality of knowledge they have and their ability to use it to their advantage. Such investors are unable to appropriately manage and control their risk. People that have this inclination are known for trading frequently and ignoring diversification. According to studies, frequent portfolio changes result in more losses than gains.
Avoiding Overconfidence Bias:
Mutual funds could be a good option for an early investor with an overconfidence bias. Mutual funds are managed by a group of specialists that invest in securities after conducting thorough research and analysis. Mutual funds have a varied portfolio because they invest in a variety of industries, minimizing the chance of losing money when stocks in one field are volatile. Trading less and investing more is another way to reduce the impact of this tendency. We compete with institutional investors that have access to more data and experience than we do when trading. As a result, it is preferable to extend your time horizon and reap the benefits of your investments.
3. Anchoring Bias
The unconscious use of irrelevant information is referred to as anchoring bias. For example, you might use a security’s purchase price as an anchor (permanent reference point) when making later decisions about that security. As a result, a person may hang on to a security for longer than they should because their reference point is the price at which they purchased it, which may be greater than the stock’s current price. Sticking to a single piece of data to make judgements and decisions about the security (when to purchase and when to sell) will result in a faulty analysis because you are depending on a single piece of data while ignoring multiple other elements.
Avoiding Anchoring Bias:
When you are under pressure to make a quick judgment, anchoring may occur. As a result, postpone your decision. Use this time to gather information from a variety of trustworthy sources. Also, do your homework. Decisions should never be made just on the basis of one element. It is important to remain receptive to new knowledge, even if it contradicts the primary information used to make decisions. Finally, instead than relying on emotions, use metrics.
4. Herd Mentality Bias
This prejudice is especially noticeable in persons who have entered the world of investing without having a fundamental understanding of finance. Finally, they demonstrate sheep behavior, i.e., following the herd/crowd. They have FOMO (Fear of Missing Out), which is an acronym for “fear of missing out.” Because everyone is purchasing that one stock, they will likewise buy it, fearing that if they don’t, they will lose future benefits. As a result, rather than being based on metrics, their decisions are influenced by the herd. Herd behavior can lead to large bubbles that eventually bust since prices aren’t justified by the asset, but rather by the investors’ actions, resulting in overvalued equities.
Avoiding Herd Mentality Bias:
You purchase a piece of apparel because everyone else is doing so in order to keep up with the latest trend. Trends come and go, but classics never go out of style. Before investing in stocks, we should assess them to find such classics. Fundamental analysis is a method of determining whether or not a company’s stock is worth investing in. Similarly, we must be cautious of stocks that are marketed on the internet. Publicity isn’t required for a good stock. Stock touting is a common strategy for increasing volume by enticing new investors to buy the stock. It raises stock prices, allowing pump and dump scheme operators to make the most money.
5. Regret Aversion Bias
You don’t want to look back on a decision you made. For example, suppose you purchased a stock for Rs 1000, but the company’s fundamentals were weak, and the stock price quickly dropped to Rs 500. The regret aversion bias prevents you from selling this stock; instead, you should hold it in the belief that the price will rise in the future. Rather than selling the stock and investing in other assets to reduce losses, you maintain it and risk further losses. As a result, this prejudice prevents you from modifying your investment judgments, making you unwilling to abandon an investment. Traders were 1.5 to 2 times more likely to sell a winning position too soon and a losing position too late, according to study. This allowed them to avoid the pain of losing profits and incurring losses because a loss isn’t considered complete until the investment is sold.
Avoiding Regret Aversion Bias:
Calculate the profit and loss exit levels for both gains and losses. For example, if your loss exit level is 8%, you’ll sell your position as soon as you’ve lost that percentage of your investment. This is one of the most effective methods for avoiding regret aversion bias and protecting yourself from significant losses.
6. Trend Chasing Bias
People have a tendency to believe that past performance predicts future results. They will look for patterns and believe that they will be true. They make their judgments, such as whether to purchase, hold, or sell a certain stock, based on this information. People usually assume that if a stock has a price uptrend, it will continue to increase, and that if a stock has a price slump, it will rarely rise again. In the first situation, people buy stocks, and in the second, they sell them. The stock market, on the other hand, is volatile, and trends will shift over time. As a result, when investing, you cannot always rely on past results.
Avoiding Trend Chasing Bias:
Do not go along with the crowd. When investors are scared, buy, and when they are confident, sell. This is because if you spot a trend, it’s likely that market participants have already noticed it and capitalized on it. So you go into a market believing you’ve found an uptrend, but you’re probably buying the stock just as it’s about to hit its high, which means you’re adding to the profits of market participants who bought it way before you did.