decisions by humans are often subject to mental and emotional biases. Mental or cognitive biases generally involve decision-making based on established notions that may or may not be true. Emotional biases, in turn, occur spontaneously depending on your personal feelings as the decisions are made.
Let’s first of all, understand the most common biases that could lead to inaccurate judgements.
1. Herd mentality
Many investors follow what others are doing instead of using their own discretion and analysis. This is often driven by peer pressure and the quest to earn more. One investor makes a quick buck from the stock market and others who feel left out join the bandwagon. In the process, they end up taking more risks than warranted. This is the herd mentality that often grips even seasoned investors.
2. Loss aversion bias
Investors often feel the pain of loss more than the joy of gains. Loss aversion bias is the tendency to avoid losses over maximizing gains. Assume an investorequally in two stocks ‘A’ and ‘B’. And stock ‘A’ goes up by 50%, while ‘B’ goes down by 50%. The investor is likely to feel the pain of the correction of stock ‘B’ more than the appreciation of stock ‘A’.
Loss-aversion bias can lead to poordecisions and is one of the reasons investors tag on to bank over that of equities. This is despite the fact that equities, though subject to volatility, have higher potential to beat inflation.
3. Recency bias
It is the tendency to give more importance to recent events. Investors often latch on to athat has topped short-term return charts, while ignoring consistency of performance over the long-term.
Investors who get swayed by recent events often also overinvest in a ‘hot’class. Because the class has been doing well recently, they believe it will continue to do so in the future as well.
Loss-aversion bias can lead to poor investment decisions and is one of the reasons investors tag on to bank fixed deposits over that of equities. This is despite the fact that equities, though subject to volatility, have higher potential to beat inflation.
4. Confirmation bias
Some investors have a belief about the market condition and often gravitate towards information sources that confirm it. For instance, if an investor expects the stock market to rally, they will scout for opinions and information in newspapers and TV channels that corroborate their belief. This is often the case when stakes are higher and investors buy too much in a stock orwithout diversifying their .
5. Mental accounting
Money for all purposes is the same regardless of its source. But humans tend to value it differently. Mental accounting refers to different values people place on money based on their subjective criteria.
For instance, one mighta hard-earned salary in safe , while using the windfall gains for speculative purposes. What is more, they wouldn’t mind losing money on the latter.
Similarly, yearly bonus or tax refunds might be viewed differently, while it is only one’s income.
Just because you are prone tobiases, doesn’t mean you have to let them guide your decisions. You can certainly work over it by learning from the mistakes and mitigate its effect by following a rule-base approach to decision making.
Investing with a goal
Once you attach a goal to a particular, you mentally start allocating money for it. So set a goal and start working towards its corpus by saving and by rationalizing your spending.
Trying to time the market is fraught with risk. By automating the process you don’t fall prey to the herd mentality.is one of the best ways to participate in equities and managing the volatility associated with them.
Staying invested for the long-term ensures you beat market volatility and let the power ofwork its wonders. As a thumb rule, seek diverse market opinion so that you don’t fall prey to confirmation bias.
By leaving the fund management to professional fund managers, you can free yourself from the perils of loss-aversion. Accordingly, choose anmix based on your understanding of risk and objectives and build a . No single class does well at all times. So, it is important to have a mix.