Behavioural Finance series summary

For the past one week, I have been writing about the various biases, fallacies and tendencies of people when it comes to money and investing. If you missed them, here are the links to the posts.

  • Anchoring Bias – The first number or information you see plays an important role in the decision you make and will be close to that number.
  • Loss Aversion and Sunk Cost Fallacy – The tendency to make decisions so that to avoid incurring losses (even as low as 1¢).
  • Confirmation & Hindsight Bias – You will always favour information that suits your beliefs or investment and hate seeing the opposite view even if it is the truth.
  • Gambler’s Fallacy – The feeling you get that you will definitely win this time or the stock has been falling down for a long time that it will soon turn around.
  • Overreaction and Availability Bias – Any event that is fresh in your memory affects your decisions, causing you to overreact to the news – be it good or bad.
  • Regret Aversion Bias – Fear of regret from any decisions causes you to miss a lot of opportunities and also lead you to make worser choices.

These are not the only biases that affects us. There are many more and the field of Behavioural Finance and Psychology in Money is vast. Check out the list of Cognitive Biases that affects us in general.

Always remember that you are not special. Every human is susceptible to these biases and the only way to avoid them all is to use critical thinking and not taking decisions in a hurry. Identify these biases, apply your knowledge and you are sure to become a better investor than most others.

Behavioural Finance: Regret Aversion Bias

Have you ever felt that a company is doing good business and wanted to buy the stock, but waited for a drop in price. And the stock never came down, you never invested and gave manifold returns only on paper. Didn’t you want to kick yourself because you failed to grab the opportunity? Why did you do it?

You know you did your analysis and found a good stock. But you were doubtful if you made the decision and the stock instead went down – you would regret having got in such a high price and sitting at a loss. The fear of regret made you not make any decision and making you miss it.

Some times we would have got in a stock at a very low price and would sit on nice profits. You would now get anxious whenever it closes red even for a day. You then decide to get out of the stock taking how many ever profits you got. After you are out of the stock, it continues to go up and give more than double the money you would have invested.

All these are called the “Regret Aversion Bias”.

Examples from my life

I have examples in my own investing life for both the types. I wanted to buy MRF which was trading at Rs.10000. I felt that it was too high and wanted to wait for a few days for it to correct a bit. It didn’t and in over a year it more than doubled the investment. A good stock, but because of my fear of regret, missed the opportunity.

Another example when I invested in Idea Cellular. The markets tanked in 2008 after I bought and I held it for more than a year or two. It reached my cost price and even gave me 10% returns. As I was very new to investing and already burnt by the bear market wanted to get out of it with at least the 10% profit. I did get out, but now I hate myself for missing the opportunity to hold the stock and get more than double the returns.

How to avoid this bias?

Before you make an investment decision spent enough time and resources to analyse the company. Its OK even if it takes an extra day or two. If it is a good company with good fundamentals, a few rupees of difference in your cost price wouldn’t matter much. Once you are sure that it is a good company and decided to invest, don’t wait forever to invest. Get in the stock and stay invested. If it corrects, you can average it, provided it is still fundamentally good.

Second important factor to remember is to not get out of the stock just because it gave your 10% or 20% returns. Try to ride the wave and see how long till it tops out. You will be more profitable waiting for a stock to top than get out every 20%.  Understand your risk taking ability and also make sure that your risk-reward ratio is favourable.

Behavioural Finance: Overreaction and Availability Bias

You travel on a particular road to work everyday morning and yesterday you saw an accident happen right before your eyes. What would your reaction be? You will begin driving carefully. Even if you don’t if you tell your family or friends about it, they would advice you to be careful on the roads.

Has the number of accidents increased suddenly? No. It is the same for the past few years. They should have advised you long time back and not just after the accident you saw. Why is it? Because of something called Availability Bias. People tend to judge things and act based on the most recent information – be it news that really happened or even opinions of others which might be false. After a few weeks have gone by, you would go back to your original driving style. As long as the event is fresh in your eyes, you would try to act based on that.

How does it affect investors?

Whenever some bad news comes out about a company, everyone tries to get out of the sinking ship as quickly as possible. This causes the stocks to fall to dangerous levels. But in real the bad news might not be that bad to cause such a huge percentage fall in prices. This works equally well for the good news too. All investors want to get in the stock based on the latest good news and drive up the prices more than its value. This is completely opposite of the Efficient Market Hypothesis – at least in the short-term.

There has been a research done on stocks in the New York Stock Exchange, where they picked 35 good stocks and 35 bad performing stocks into two portfolios. Over a 3 year period, they found that the bad stocks portfolio consistently beat the market index and the “good stocks portfolio” consistently under performed.

This shows that investors overreacted to the bad news and drove the stock prices down a lot. Similarly they overreacted to the good news and drove the stock prices all the way up. Over a long time period, this averages out and the real value of the stock comes out.

Overreaction

This affects not only investments in stocks, but also people buying Mutual Funds or ULIPs because the agents showed how big the returns were in the past.

How to avoid Availability Bias?

As always do your own analysis and research before making any decisions. Don’t listen to the talking heads in the various financial TV or media. It is usual for the media to over-hype things because that is what gives them money. Remember never make investment decisions when you’re emotional. And remember what all Mutual Fund companies say at the end of their advertisements? “Past performance is not an indicator of future performance”.

Have you ever overreacted to any news and realised later that it was stupid? Leave your experiences in the comments below.

Behavioural Finance: Gambler’s Fallacy

Coin TossIf you and your friend has a bet on coin flips and for the 10th consecutive time (you are using a fair coin), you called out “heads”, but you lost, what would your thoughts be on the 11th toss?

“I have lost 10 times in a row. I am definitely going to win this time.”

Isn’t that what any normal human would think? But what does laws of probability and Math say? Each coin toss is an independent event and the probability is exactly 50-50. It doesn’t matter if it falls tails for 10 times or 100 times, the next toss can either turn out to be a head or a tail, in exactly 50% probability. But normal human mind doesn’t think about probability and math when he thinks “This time it I will definitely win”. It is the irrational mind that makes you think in such a way.

This is what is called Gambler’s Fallacy. This is more commonly seen in the slot machines, where people keep putting in coins after coins, thinking they are close to hitting the jackpot. When in reality the probability is the same on every coin they put. The machine is designed to payout in a particular ratio of winnings only and playing more doesn’t increase your chances of winning. Side Note: You will definitely lose more than you win in any slot machine.

Gambler’s Fallacy in Investing

This is widely seen in the field of investing/trading and many would have fallen in this trap. They would see a particular stock falling from Monday to Friday for 5 days straight. They would immediately think, the next trading day it will surely go back up and I can make a quick profit. Let me go buy now and sell on monday.

They fail to understand or analyse why the stock has been falling for 5 days – it could be numerous reasons like, policy decisions, competitors, losses, higher debt, corporate governance issue, etc. Without knowing the details of the stock movement, no one can predict when the stock will stop falling. It is foolish to think that the stock has nowhere to go but up. But numerous investors think like this and buy into worst possible companies and lose all their money.

How to avoid it?

First you need to understand that in any independent event, the odds of any specific event or outcome is the same regardless of how many times it has happened in the past. This is even more important in stock market because there is too much external noise and you wouldn’t even think clearly because of all the high volume trading.

Never buy a stock just because you “feel” that the trend has been downward for too long and will reverse any moment now. Always decide after doing sufficient fundamental or technical analysis before investing in stocks. Its better to wait till it goes upwards with a confirmation even if it means losing a few rupees than to hastily invest before it has reached a bottom.

Behavioural Finance: Confirmation & Hindsight Bias

Confirmation Bias

Fundamental analysts or people who believe such reports need to be aware that they might be under the influence of Confirmation Bias. This is the tendency of people to favour information that confirms or matches their beliefs.

Lets say you are the ardent supporter of a political party. You would see that there are more and more news articles that confirm your views about how the party will win the majority in the elections or how the leader is the best thing to happen to India, etc. If your friend supported the opposite party, he would see more articles supporting his leader/party.

This doesn’t apply just for individuals, but also to organisations or even governments. They keep searching for information which supports their theory and would hate anyone who would say otherwise. They would even say the opposing view is false and wouldn’t believe it.

How does it affect Investors?

We as investors are heavily affected by it, especially if you base your investments on someone else’s analysis. Numerous analysts publish reports about stocks and why it is a good investment strategy. Once you made your decision to invest in a stock, you would look for reports and news which support your decision.

You would read how all analysts are taking how good the company is, how cheap the valuations are, etc. You would go out of your way to prove that your investment was the best decision, even though the company might not have customers or revenues to match the high price.

HindSight Bias

Hindsight is 20-20You know how they say hindsight is always 20-20. This is also called the I-knew-it-all-along effect. After a disastrous event has occurred, you would see many people proclaim that they knew it was bound to happen all along, even though there was no way they would have predicted it.

There were numerous bubbles in the history – tech bubble, sub-prime crisis, even the tulip bubble. Every time after the event numerous experts came out saying “We knew this would happen all along. It was just a matter a time.”

In stock markets, this could be very dangerous as it makes the trader/investor to feel overconfident. When you keep picking numerous stocks which gives you good returns, you would soon believe that you have superior stock-picking skills.

Avoiding these biases

To avoid both these biases, it is important that you realise that what you read is not always true. If you want to invest in a particular stock, instead of reading reports and articles that praise the stock, try searching for negative reports. Actively look out for reasons which would make you not to invest in it. Be the devil’s advocate and then invest if you still think its a good stock.

Have you ever had a similar situation where you knew or believed that you predicted something would happen? Tell me more about it in the comments below.