Human decisions and behaviour are all subject to a host of biases on a variety of issues. How does a bias impact you? They push you to take decisions that you prefer to take than actions that you ought to take, given the situation. Investment decisions too, are certainly not exempt from bias. Let us discuss some of the common investment biases and how to overcome them.
Investors tend to base our decision from the first piece of information that is available. This bias is also called focalism. Once a decision is made based on the first piece of information, any subsequent information is also inferred in a such a way that it anchors the initial decision made.
Let us look at an example – We may end up holding loss making investments/funds based on the first piece of information that was received regarding the investment. Any subsequent fall in the value of the fund/investment may be due to actual deterioration in the fundamentals, but this bias will make investors to either hold on to bad investments or even worse buy more.
Investors can overcome this bias by properly valuing subsequent data around the anchor by proper research and further evidence from the new data.
Bandwagon effect means taking a decision primarily because a group of people are doing it regardless of what an individual may believe in. This is also called herd mentality. This is a very common phenomenon in the equity markets. If you are one of those investors who exited your fund/investment in stocks right after the “ surgical strikes” carried out by India on Pakistan fearing a sustained war, only because a host of people you knew were exiting theirs, then you are influenced by this bias.
The best way to overcome this is to stick to your objective and carry out your own research or seek professional advise rather than following an action performed by a group of people.
It is the expectation that a particular event may or may not happen based on past information . To put it simply, it is the expectation of future events based on the past. This is a very common bias that tends to influence a lot of investors. The best example is when investors invest in a stock or a fund on the premise that it had delivered stellar returns in the past and expecting it to perform in the same way in future as well. Another example will be those set of investors who stay out of equity markets completely fearing a 2008 like crash. Gambler’s fallacy is not easy to stay away from. However, one way to overcome it to some extent is to avoid looking at short-term trends to predict the future. Long-term trends have shown better chances of repeating (subject to external factors of course). Similarly, keep the law of averages in mind at all times. Chance or luck plays a large role in the short term (as told in the book Why smart people make big money mistakes by Gary Belsky (Author), Thomas Gilovich ) but will average out in the long term. Do not therefore get swayed by short-term high returns or be spooked by short-term market falls. In a mutual fund for instance, look at the fund consistency across all times than looking at its performance in rallying markets alone.
It is natural to think that more the choices the better it is. However, in reality, too many choices lead to information overload and therefore a state of decision paralysis. A classic example is the number of funds that there is to choose from within the mutual fund industry. This often confuses the investor and keeps him/her from making a choice. This ultimately prevents him from saving in a good instrument.
One way to overcome this is to narrow your own choices through research (which is a full time task by itself) or simply ask your advisor to provide you with the right set of stocks or funds that fit your criteria. As long as the funds or stocks given meet the minimum criteria you have set for them (like the fund should have beaten the benchmark consistently) you should move on with your choice.
Zero risk bias
Zero risk bias occurs when we want to completely eliminate one risk even if there are alternatives with better solutions with reduced risk. For example, most investors like certainty of returns. It holds zero-risk bias where investors have a zero tolerance for uncertain returns. In such cases they end up choosing investments that provide sub optimal returns in the pursuit of ‘certainty of returns’. One of the best examples is when people invest in fixed deposits even if the returns from the investment delivers negative real returns (returns post inflation).
This bias can be overcome by taking the help of an advisor who would assess your risk profile and help you with the right allocation of assets. It can also be overcome by understanding the probability of such a risk occurring if an alternative, superior yielding option were chosen.
Understanding your own risk tolerance by discussing it with an expert, understanding where you need to get and the strategy that will get you there will provide confidence to overcome many of your investment biases.