How Biases Affect Investor Behaviour
Published by Sharekhan Education | March 23, 2021
How Biases Affect Investor Behaviour
Amit Pathak | Sharekhan Education
“Most of us have a sense that our past life experiences often frame how we respond to events. But, what we may not realize is that majority of us tend to rely more on mental shortcuts and biases to make decisions, which can lead to less than ideal outcomes. Some of the most common cognitive biases that can lead you to make less than optimal investment decisions are:.
1. CONFIRMATION BIAS:
Humans tend to search for, interpret, focus on and remember information in a way that confirms our preconceptions. Investors might inadvertently look for information that supports their beliefs about investment and fail to see the information that presents different ideas. Having a one-sided view can lead to poor investment decisions.
2. OVERCONFIDENCE EFFECT:
Humans tend to overestimate or exaggerate their ability to successfully perform a given task. Overconfident investors feel that they are better than others at picking the best stocks and timing to enter or exit a position – a behavior that can lead to more frequent trades and market timing, which will impact returns.
3. LOSS AVERSION:
Humans feel the pain of loss more severely than they feel the joys associated with gains. This loss aversion can cause investors to sell winning investments too early, hold losing investments too long, or possibly assume additional risk in an attempt to make up for potential losses.
4. BANDWAGON EFFECT:
Humans are frequently compelled to take a particular action primarily because other people are doing it, regardless of their own beliefs, which they may ignore or override. In investing, we see this phenomenon can play out during bull markets and in asset bubbles, when price spikes occur when investors all flock to a particular asset class.
5. HINDSIGHT BIAS:
Humans tend to perceive events that have already occurred as having been more predictable than they were before the events took place which can result in an oversimplification in cause and effect. An investor who believes that they knew everything about every situation has a strong inclination to become overconfident.
Some measures, like keeping emotions in check, staying diversified, considering the other side, and rebalancing portfolios regularly can help overcome the cognitive biases discussed above up to a certain extent.
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