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October 30, 2017

Know your behavioural biases to improve your investment decisions

In an ideal world, human beings would behave rationally at all times and not be swayed by temptations or get easilydistracted. But as this year’s Nobel Prize winner for Economics, Richard Thaler, has shown in his pioneering work onbehavioural economics and finance, real humans are inconsistent and are driven by their social preferences or biases, emotions and also their lack ofself-control. And that holds true of their investment decisions too. This article takes a look at some of the behavioural biases that can affect investing.

 

Like the stock markets, investors also go through an emotional cycle that can be mapped onto the investment cycle, as illustrated below. This leads tosome common investment behavioural biases.

Overconfidence Bias: Has your equity fund performed rock-solid this year? Areyou tempted to invest more based on this success? If yes, you probably have anoverconfidence bias. Investors with this bias try to take unnecessary risksswayed by their recent success in an investment. Investors typically ignore therisks, which often results in poor investment decisions.

 

Confirmation Bias: Investors try to give more weightage to information thatconfirms their investment thesis while ignoring facts that go against this thesis.For instance, investors who have a liking for small and midcap stocks often readrelated success stories and interviews that support their thesis rather thanevaluating the whole picture.

 

Loss Aversion Bias: The equity markets are at all-time highs today. Yet, severalinvestors have failed to participate in the current rally because they are highlysensitive to losses. Suppose a person has to choose between an investment option that does not offer negative returns but has lower returns than anoption that can generate higher returns but with some risk. Investors suffering from this bias will, in all likelihood, choose the first option withoutunderstanding the investment horizon or their own risk-return appetite.

 

Anchoring Bias: This is the tendency to anchor or latch on to an initial reference point and take decisions based on it even though it may no longer belogically relevant. For instance, Mr A quickly buys a stock at Rs 60 after it has fallen 40% from its all-time high of Rs 100. As he was anchored to the Rs100 price, he considers the current price cheap. However, such decision making can be risky as he may have ignored the event that resulted in the 40%fall in the stock and which could have a negative impact on the company’s business in the long run.