So many things have been written and read about finances. Some people read it while majority of them ignore and refuse to learn about this important area of life. Some are so sure that they will not understand finance that they have developed a fear in this aspect. This article specifically is addressed to those majority and its only about you and nothing to do with numbers or finance jargon.
In 2001 Dalbar, a financial-services research firm, released a study entitled “Quantitative Analysis of Investor Behavior”, which concluded that average investors fail to achieve market-index returns. It found that in the 17-year period to December 2000, the S&P 500 returned an average of 16.29% per year, while the typical equity investor achieved only 5.32% for the same period – a startling 9% difference!
In my view knowledge, skills and information about finance is only secondary to your behavior for making money, for the very reason that all of it tend to be colored by your behavior. Hence read on and may be you can identify yourself with any of these biases, which have been big blocks in your path to prosperity
- Loss Aversion/ Regret Bias – It is estimated that losses are felt between two and two-and-a-half as strongly as gains. Thus the pain of losing Rs10000 is at least twice the pleasure of gaining Rs10000. This also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. That is why investors might choose to hold their losers and sell their winners: they may believe that today’s losers may soon outperform today’s winners. Real Life case – I met this person who claimed that in past one year of his history he has never lost money on equity trading. More than being impressed I was astonished only to find out that he had taken delivery of all the loss making trades and called them long term investments
- Confirmation Bias – We tend to suffer from confirmation bias and thus reach a conclusion first, only thereafter do we gather facts and then see those facts in such a way so as to support our pre-conceived conclusions. We like to think that we carefully gather and evaluate facts and data before coming to a conclusion. But we don’t. Real Life Case – Due to some astrological suggestion one of my client has concluded that he will make more money in real estate than in any other asset. Every time I speak to him about asset allocation he tends to support real estate with all the collected information and has a portfolio heavily skewed towards it.
- Choice Paralysis – Intuitively, the more choices we have the better. However, the sad truth is that too many choices can lead to decision paralysis due to information overload. In my view either ways it leads to inaction. Too many choices confuse us and not having too many choices lead us to “Aur dikhao” syndrome. Real Life Case – I wanted to buy a wallet and could not find too many options in a leading multibrand store. I decided to go online and was so puzzled with the amount of choices and information that ultimately I ended up not buying anything.
- Herd Mentality – This is the tendency to follow the crowd due to the strong desire among humans for peer approval. This makes it difficult for us to act based on our personal convictions or in a contrarian manner. Real Life Case – Reliance power IPO, is one of the best example of herd mentality. In 2007 ADAG group announced this IPO and everyone wanted to subscribe it. I remember people opening demat accounts just to apply for this IPO
- Availability Heuristic – This is simply our tendency to jump to conclusion based on easily available information. Perhaps most significantly, we inherently prefer narrative to data. Stories about how people have lost money in shares and stories about how a property bought for few lakhs years ago is now worth crores influence us strongly. This is probably one most dangerous short cut we tend to take while taking an investment decision. Real Life Case – This person I met invested in mutual funds. Since he did not wish to hire an advisor and nor had the time to research, he equally invested all his money in 5star rated funds.
- Recency Bias – It’s the tendency to extrapolate from the recent past and to think that a trend will continue in the future as well. This bias makes people plan things in a way that is completely detrimental to their finance. People tend to see a recent history of performance and assume that the trend will continue. Real Life Case – In 2007 many life insurance agents sold ULIP showing the returns in recent years. The most common pitch was that if the insured pays only for 3 years(regulatory requirement) returns generated will be enough to cover all the future premiums. This one person I met around same period was absolutely in love with ULIPS because he saw amazing returns on ULIP which he had never experienced on traditional plans and fixed deposit.
- Anchoring – In the absence of better or new information, investors often assume that the market price is the correct price. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities. In bull markets, investment decisions are often influenced by price anchors, prices deemed significant because of their closeness to recent prices. This makes the more distant returns of the past irrelevant in investors’ decisions.
These cognitive biases plague us and make it difficult for us to make good choices. Knowing about them is imperative if we are going to deal with them. We would always be wise to factor in these biases when performing analysis and making decisions. Unfortunately, we all tend to share a “bias blind spot” — the inability to recognize that we suffer from the same cognitive distortions that plague other people.