Investors are today bombarded with information left, right
and centre.
This overflow of information is at an unprecedented level
today due to how easily information can be disseminated these days.
Point to consider here is that information does not necessarily
imply that it is true, a lie is easier to spread but the truth is sustainable.
Information and knowledge are not the same, the former may
be right or wrong but the latter is mostly right.
Humans are more glued to their screens than ever and therefore
it is easier than before to accumulate views, in the process of gathering such
views we often overlook the simple yet very important point that such views are more
general in nature than personal.
There is a very good reason why they say the Person in ‘Personal
Finance’ is more important than the Finance.
What is Cognitive Bias?
Cognitive Bias is the tendency to behave in a manner that
can be considered irrational due to our inability to look at a certain matter
objectively in a manner as neutral as possible.
This clouds our judgments and the way we look at everything,
we see what we want to see even though that may not be visible and we refuse to
see what is visible right in front of our eyes.
This is often due to our pre conceived ideas of a particular
subject and our inability to differentiate reality from fiction.
To better explain this using a simple example, we all know
the over indulgence of sweets is unhealthy.
Now let’s say you are unable to rein in your desires for
something sweet and dig in deep and research till you find out an article that
says that indulging in sweets occasionally is nothing to fret about.
You interpret this with your own definition of indulgence and occasionally so as to get your way.
This accommodative behavior displayed to achieve your sole
goal without any regard for other points that are in fact more conclusive and
rational can be termed as cognitive bias.
Mentioned below are some of the cognitive biases that
investors face when gathering information and taking investment decisions.
Overconfidence Bias
Overconfidence bias stems from one’s ability to overestimate
their skills while underestimating other factors like luck, timing, etc.
Imagine one fine day you were able to predict the market is
going to be negative all day and therefore conclude that it is going to be a
great day to invest.
Your reasoning for the market staying negative and the real
reason for the market staying negative could be varied but that does not matter
to you, what matters is that you were right.
This false sense of accurate prediction elevates your
fallacy which in turn harms your portfolio.
The idea that one should not try to time the market is a
tale as old as time and yet it cannot beat an investor’s overconfidence bias.
Herd Mentality
As the term itself explains, herd mentality is when you
follow a group of people blindly assuming the group knows what they are doing.
It is easier to be compliant when something is being done by
a large group, rationality goes for a toss cause the actions of the group seem
so trustworthy.
This is very common when looking at trends and numbers, most
retail investors tend to invest when the markets go up and redeem when the
markets go down.
Another trend is to do what is popularly known as Profit Booking even when the goal could be years ahead and unrealized.
Often investors are appraised as to where their friends,
relatives and colleagues are investing and decide to ape the same, this
behavior is encouraged by the belief that if someone else is investing their
hard earned money into something then they know what they are doing.
Anchoring Bias
Anchoring bias is the tendency to focus on just one specific
piece of data and use it as a reference point for everything else.
For eg. You look at a fund’s one year performance showing
30% and decide that it’s really good without considering other factors like the
reason for performance, peer performance, relative market performance, whether
past performance is a good parameter or not, etc.
Your decision to invest in the fund was anchored purely on
the returns factor without accounting for other far more important and relevant
factors.
When the fund does not perform as per your expectations ,
you blame the fund rather than your analysis.
Prior to the covid lockdowns both IT & Pharma funds were
laggards compared to vanilla funds, expectedly their returns got a boost during
and the immediate period post the covid lockdowns which naturally resulted in
more retail investors jumping on the bandwagon only to be disappointed later
since the returns could not keep up with their expectations.
This is exactly how thematic funds work though, they tend to
be more volatile.
Confirmation Bias
This alludes to selectively filtering information that fits
with your pre-determined narrative while discarding the rest.
Let’s say your portfolio consists only of small cap funds.
You therefore are on the lookout for only positive news with
regards to the sector that would reaffirm your decision to stick with such
funds, the authenticity of such news and your risk profile is irrelevant in
such cases.
Confirmation bias can be self-destructive in all walks of
life and not just in investing.
Hindsight Bias
Hindsight bias is the tendency to overestimate one’s ability to predict an outcome of an event by connecting it to past events.
No one can accurately foresee a market crash or the exact
timing of an extended bull run.
Nevertheless Raj believes that the signs of the market crash
of March 2020 were all along visible.
In order to reaffirm this idea he points out to other factors
previous to the crash that reinforces this idea.
This could be past events like the 2008 crash or the dot com
bubble, the panic due to the inadequate knowledge surrounding covid, the past
market trends, investor behavior and so on.
The dots are joined and guided to arrive at a conclusion
that the signs were apparent and he was right all along, this of course does
not answer why he did not vocalize the said signs before.
Humans are inherently emotional and therefore biased.
An investment portfolio though has no place for emotions,
you don’t construct a building on a weak establishment merely cause you like
the surrounding.
The more reasonable solution to tackle biases would
therefore be methodical.
We are more likely to commit mistakes when we are more
emotionally involved in a process, it’s in human nature.
Stick to your asset allocation, assess your risk profile, avoid outside noise, try to stay invested as long as your goals are reached instead of timing the market, keep emotions at bay and stick to quality advice rather than being influenced easily.
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