5 Behavioural Biases That Influence Our Investment Decisions

We develop certain biases that influence our decisions in various aspects like finances, career, relationships, health, spirituality, etc. In this article, we will focus on five behavioural biases that influence our investment decisions.

Behavioural Biases That Influence Our Investment Decisions

1) Confirmation Bias

Confirmation bias happens when an individual has already formed a belief or has pre-conceived notions about something. They will then look for information across various channels and focus on the sources that confirm their belief.

For example, an optimistic investor will look at information on how the stocks have performed well during previous bull markets and created wealth for investors. Similarly, a pessimistic investor will look at information on how stocks crashed during the previous bear markets and destroyed investor wealth.

Investors should look at long-term data spanning across multiple economic/business cycles. It will show how a bull market follows every bear market and vice versa. Also, India is one of the fastest-growing economies in the world and is expected to continue to do so in the future. Hence, stock markets are expected to perform well in future. However, the growth is never linear. There will be bull (over-optimistic) and bear (over-pessimistic) phases on the way to wealth creation.

You should always invest for the long term and give your money time to ride over multiple economic/business cycles. Also, you should invest through the systematic investment plan (SIP) mode so that your investments get averaged out over time. In the long run, you will benefit from the power of compounding and create wealth for yourself.

2) Herd Mentality Bias

A herd mentality bias happens when an individual goes with the decision of the majority of people rather than going with their own judgement. The belief is that when the majority of people are doing something, they are doing it for good reasons and going with them will benefit the individual. In the process, an individual ignores their own analysis and risk appetite.

In the investing world, most bubbles are formed due to herd mentality bias. When many investors flock to the same asset class due to herd mentality bias, it results in a bubble. One of the reasons for the herd mentality bias is the Fear of Missing Out (FOMO). We see people around us who have invested in an asset class and boast of their paper/booked profits. At some stage, we give in to the temptation and jump in.

At some stage, the bubble bursts. We would be lucky to cash out before the bubble bursts and retain our profits. However, unfortunately, in most cases, retail investors are the last to invest at frothy valuations and are usually left sitting on losses after the bubble bursts.

Some examples include investing in stocks at high valuations, investing in cryptocurrencies like Bitcoin during the frenzy, etc. The Tulip bulb mania in the 17th century in Holland is a well-known example of herd mentality. In 2008, in the US, there was a rush to invest in houses and securities backed by them. When the bubble burst, the houses and the securities backed by them lost value and investors were saddled with losses.

In India and across the world, some operators jack up stock prices as part of the pump-and-dump scam. The operators first buy the stock at low prices. They start spreading good news about the company, create false narratives and encourage people to buy the stock. When the stock price reaches a certain level, they dump the stock and book profit. Eventually, the scam unfolds, the stock price crashes and investors are left holding the stock with huge losses.

3) Loss Aversion or Risk Aversion Bias

A loss aversion or risk aversion bias happens when an individual is not willing to take any risk for their investments. Some individuals try to play safe. They invest in bank fixed deposits or Government small savings schemes with low to no risk. In such a scenario, they will have to be content with low returns. These low returns may or may not be able to beat inflation. The loss aversion or risk aversion bias develops based on past experience(s) of losses that may have stemmed from earlier investments.

For example, an individual may have invested in stocks directly based on some tip from a friend, family member, broker, etc. They may have incurred a loss on that investment. Two things can happen in this case. The first is that some investors hold on to the loss-making investment. They are not willing to book the loss and rectify their mistake. Some even average out by buying more at a lower price.

The second is that based on this experience, they decide not to invest in equities or equity instruments like mutual funds in future. As a result of the loss aversion or risk aversion bias, they forgo the opportunity of making good returns from equity mutual funds in the long run.

Equity mutual funds can be volatile and risky in the short term. However, as the investment time horizon increases, the risk goes down. For example, as per past data, the chances of negative returns from the Nifty 50 fall to 0 for an investment time horizon of 7 to 10 years or beyond.

Individuals should always consult an investment expert and get a customised financial plan. Based on factors like your age, risk profile, investment time horizon, etc., the investment expert will recommend the appropriate mix of mutual funds for investment.

4) Anchoring Bias

An anchoring bias happens when an individual has some initial information about something and bases their investment decision on it. A common example of anchoring bias is when investors select mutual funds based on the best performers in the last one year. As has been seen in the past, the best-performing mutual funds from last year hardly make it to the best-performing list beyond one to two years in a row. It has also been observed that some funds that topped the list last year may find themselves at the bottom of the table in the following year.

Investors should choose mutual funds that are consistent in delivering returns. As long as the average returns of a fund are equal to or higher than your expected rate of return, you may leave out the best-performing funds. An investment expert can help you identify mutual fund schemes that are consistent in returns.

5) Familiarity Bias

A familiarity bias happens when an individual sticks to what they know rather than exploring new options along with what they already know. For example, earlier individuals would invest in gold through coins and bars. Then came gold ETFs and gold mutual funds. Even though these are better ways of investing in gold, some investors will give them a miss and stick to gold coins and bars due to the familiarity bias. After gold ETFs and gold mutual funds came Gold Sovereign Bonds (SGBs). However, some investors will stick to gold ETFs and gold mutual funds even though SGBs are more tax-efficient due to the familiarity bias.

Some investors stick to a particular asset class as they have developed a comfort zone for it. In the process, they are expose themselves to higher risk with a single asset class. They miss out on diversification due to familiarity bias. Diversification helps earn better risk-adjusted returns.

Don’t Let Behavioural Biases Hamper Your Investment Journey

Certain biases can create roadblocks in your investments and thus hamper your financial planning journey. Instead, it is recommended that you work with an investment expert who can address these behavioural biases with data and facts and help you overcome them. You should not let emotions overtake your investment decisions. Infact, you should map your investments to your financial goals so that you can focus on achieving them. You should invest in a disciplined manner for the long-term till your financial goals are achieved and you attain financial freedom.