Are you a rational investor? 3 investment behavioural biases that you might not be aware of
Recency bias, herd mentality, and confirmation bias are the common behavioural biases many investors suffer.
We like to think that we make rational decisions during our investment decision process. But, we are not always as reasonable as we believe we are regarding money and investing. There are various investment and trading strategies that one can apply. However, these strategies and financial theories are based on the assumption that market players are rational and investors don’t make any mistakes.
However, this is not the case. And there is a branch of research that explains our peculiar conduct. Behavioural finance relies on cognitive psychology to understand investor psychology in the real world.
The factors that affect our investment behaviour and decisions are known as behavioural biases. These biases can impair our decision-making abilities and hurt our long-term success.
As humans, we must be conscious of how our behaviour affects our capacity to make financial decisions. We may have a higher chance of attaining long-term goals if we can detect the behavioural biases that may influence our financial decisions.
Here, we will discuss some of the common types of investor biases:
In our day-to-day lives, we remember the recent events in greater detail than our past memories. It isn’t very different when it comes to making investment decisions.
Most of us tend to suffer from recency bias.
We can say that we are a victim of recency bias when we place an excessive amount of weight and make investment decisions based on recent market events expecting the events to continue in the future. It may cause them to make irrational actions, such as following a hot investment trend or dumping stocks during a market downturn.
Recency bias can cause you to deviate from the detailed financial plan you created with your financial advisor. As a result, you might not achieve your financial goals on time, which can have long-term adverse effects. So, in a gist, you will sabotage long-term goals for your short-term satisfaction.
Let us consider the current market scenario. If we consider the past five days, the Nifty 50 is trending down and is down 3.81%*. However, if we consider the past five years, we can see that the Nifty 50 is up 63.66%. In this case, investors with recency bias are likely to pay more attention to the near-term data and ignore the long-term results.
If you are suffering from recency bias, it would be wise to look at the long-term performance of the markets and how the long-term trends impact your investment outcomes.
Herd mentality bias is another prevalent behavioural bias that describes an investor’s tendency to follow and mimic what other investors are doing. Think about this as peer pressure but instead of students, it happens with investors.
It is very natural for humans to follow the herd, and we are hard-wired to be in a pack. There are multiple instances of herd mentality and its impact on the financial markets. The tulip mania, the dot-com bubble and the real estate bubble are some of the prominent examples.
Let us consider the dot-com craze of the 1990s. Many dot-com businesses didn’t have financially sound business ideas, yet many investors invested because everyone else was in these stocks.
It is essential to understand that going against the grain can be emotionally or psychologically draining. Psychologists have discovered that being a contrarian investor might induce physical pain.
Here are some of the steps that you can take to avoid herd mentality:
- Conduct your investigation and begin investigating the facts for yourself. Reduce your dependence on others for your financial moves.
- Do your homework, then form your thoughts and make your ultimate decision.
- Ask questions about how and why people do what they do, and then make your own choices.
- If you’re distracted, whether it’s from stress or something else, put off making decisions.
Confirmation bias describes how people instinctively prefer information that supports their existing ideas. For example, if you like tea more than coffee and type ‘tea better than coffee’ on Google, you will find articles that will tell you that tea is better than coffee.
While the tea vs coffee example might be harmless for many of us, taking investment decisions based on resources that align with your existing ideas might be dangerous.
Confirmation bias is where investors seek information that validates their existing ideas while ignoring facts or statistics that contradict them. This psychological phenomenon arises when investors filter out potentially valuable facts and opinions that are contrary to their pre-existing assumptions.
When investigating an investment, people may unwittingly seek out or favour information that confirms their preconceived assumptions about the asset or strategy while failing to notice or undervaluing any evidence that gives alternative or contradicting viewpoints. Confirmation bias can lead to investors making poor decisions, whether it’s in terms of investment selection or trade timing.
Steps that you can avoid confirmation bias:
- Seek out opposing viewpoints, even if they make you uncomfortable at first. Try to comprehend the rationale behind the opposing views.
- Don’t rely on one source of information when forming opinions about an investment option. Examine a variety of information sources.
- To make better investment judgments, broaden your investment understanding of diverse investment concepts, financial markets, and the economy.
It is essential to know your own psychological biases and understand how they can affect your decisions as an investor. Therefore you need to study these behavioural biases.
In the above article, we overviewed the three vital behavioural biases that can affect even the most experienced and rational stock market investors. The key takeaway is that you need to be aware of these biases and ensure they do not seep into your investment behaviour strategy.