Avoiding Biases That Influence Investing Habit
January 05, 2022
Avoiding Biases That Influence Investing Habit
“How much money can you lose in the stock market?”
Last week, two young professionals, one aged 26 years and the other 34 years, both working at the same company in the same city, with reasonable similar family backgrounds, came to seek advice on investing. As we discussed stocks, bonds and mutual funds, I asked them the above question, something I often ask young investors. The 26-year-old said, “Not much. Maybe 10-15%.” The 34-year-old said, far more emphatically, “A lot. Definitely 60-70%.” Why such a big difference in the answer to the same question, for which the data is well known, debated and discussed? Simple. The 34-year-old’s first experience with equities started just before the 2008 crash, and the 26-year-old started investing just a few years ago.
The contradictory opinion between two investors is largely because of a single experience, but it leads to a big difference in the investment decisions they both make. Neither is right or wrong, but both come with their own pre-conceived notions, or what you would call bias that influences their behaviour. “Behavioural bias” is not just a complex sounding investment theory, but a concept that has intrigued researchers around the world. Its core is very simple – we are all human, just like the two investors above, and because of our experiences, conditioning and personalities, we think in certain ways, follow certain non-existent thumb rules. Be it investing or life, biases always make us do things that are illogical and irrational.
Today, we study 4 basic biases, how they influence mutual fund investing, and most importantly, what we can do to avoid them.
We are shaped by beliefs, which we hold onto adamantly, and with age, we learn and unlearn them. However, for a few people, these beliefs are so strong, that they tend to filter any view that doesn't align with these beliefs. In investing, the most common way anchoring mind-set thinks is to decide future return expectations based on past returns. For instance, investors who started a SIP in mid-caps in 2017 looking at 18%+ annual returns, will invest assuming markets will do this consistently year on year, forgetting that a year like 2018 will come along, only when mid-caps will indeed fall. In fact, after this fall, the decision to hold the SIP should be driven by a rational assessment – “Don't stop SIPs at dips”, not anchoring bias. The best way to handle anchoring bias is to never let one factor – returns – drive decision making, because there's a tendency of your mind getting anchored to it. Always view returns as an outcome of an investment journey and not a decision-making driver. The other trick is to avoid evaluating portfolios frequently, to tide through periods when returns are below expectations.
2. Loss aversion:
Loss aversion is that simple feeling of regret, after making a choice with a bad outcome, and we all want to avoid “losses” at any cost. Losing Rs. 10 is actually twice more painful psychologically than the joy of gaining Rs. 20 - on the same investment. This desire to avoid losses keeps investors away from investing in equities, and missing wealth creation opportunities. It also keeps investors from exiting sub-par investments that are in the red, because we don't want to realize the loss. The best way to handle the fear of loss is to adopt asset allocation strategy which strikes a balance between risks and returns, and create a portfolio with loss levels that are digestible to you. If you invest in a Rs. 100 portfolios, Rs. 20 divided in five different asset classes, even if one or two have a bad run, the good outcome in the other few will preserve your peace of mind!
3. Choice paralysis:
We all are spoilt with choice today, whether it is with clothes, restaurants, phones or investments. Even worse is we're swamped with information through print, electronic, and social media. It's time we - learn to say – “Enough!” because excess choice only makes decision making - difficult -, since we're unable to - decide. In the MF world, if you were to do a simple one-time investment, you can get lost in an array of fund houses and schemes, for any goal or risk appetite. Finding the right scheme if you just looked at the list, is a scary choice! The way to avoid choice paralysis in mutual funds, as I often tell investors who ask me, “What is the best scheme to invest in?” is to start bottom up, rather than attack 450 equity funds. Understand your goals, and then filter funds based on investment objective and tenure, narrowing the universe to a limited number of funds, that makes this selection task easier.
4. Herd mentality:
We love following what others are doing, so much so that if a lot of people are at a restaurant, visit a destination, or take a certain route, it's usually considered a good one! Even if you don't have a positive view on an investment, you are more likely to do it because of the herd. This “power-of-the-crowd” mentality has created many a bubble in financial services, as markets run ahead of valuations because of the impact of flows and liquidity. Theme based investing in mutual funds, as well as a rush to risky asset classes like credit funds and small cap funds, are often herd mentality playing out, as people look at exemplary numbers with no reference to history or benchmarks. Herd mentality is the hardest bias to avoid, and the best way to avoid it is again, fundamental analysis. Ask difficult questions that no one is asking, and don't invest till you find the answers!
Biases are inevitable hurdles in making decisions, and awareness of bias is an important step, a check box that you are not falling into a trap. A lot of time is often spent on “When do I invest?” and “What do I invest in?” Do the bias check – and ask a third question – “Why am I investing?”