“A key to success is Emotional Stability” Warren Buffett.
How we behave is more important to be more successful in investment.
Money is 80% behavior, 20% head knowledge. It’s what you do, not what you know. – Dave Ramey
In this blog, we will see a few interesting behavioral biases of investors, that influence their financial decisions.
These biases can impact the behavior, and decisions of investors. It impacts how investors spend or invest money.
Mental accounting
Meaning:
People treat money differently depending on its source. It matters from where it came and what we think it should be used for. It is called “Mental Accounting”; a mental compartment related to the source and use of money.
If we are saving for some emergencies or let’s say for a house, we tend to protect it cautiously and categorize it separately. On the other hand, we can easily spend the money that is gifted.
Hence, most people spend bonuses on luxury items but would save that same money if it is a part of monthly salary. Earned money has been mentally allocated to an account, but the Rs. 1000/- you find on the street hasn’t been.
How to deal with this?
Create a budget to guide your financial decisions so as to better determine when to save and when to spend money, create a plan ahead of time, how to spend bonus gains. .
Loss aversion
Meaning:
‘Loss’ is a word that everyone wishes to avoid. In a “Loss aversion” bias, people try to avoid losses over seeking gains.
It is found that ‘people are more sensitive to losses as compared to gains’ when making decisions. This is found in a scientific study done in 2019.
How to deal with this?
Don’t let your emotions overpower you, especially when it comes to making a financial decision. Create an investing strategy, protect your family with Insurance, invest as per your Risk Profile and stick to the basics.
Overconfidence bias
“Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident.” – Carl Richards.
Meaning:
As the name suggests, the tendency to see ourselves as better than we are is “Overconfidence bias”. It is most common in Investment and managing the portfolio.
Overconfident investors generally do not manage and control risk properly, as published in the International Journal of Management 2020.
You should know what you are doing, and why you are doing it, and it builds confidence, but overconfidence regarding the knowledge, trying to time the market, and constant churning of the portfolio can harm and lead to lower returns.
How to deal with this?
Overconfidence leads to over-estimating abilities and knowledge, which can lead to poor decisions.
For beginners, it is important to consult a professional to design a better-investing strategy. Don’t try to time the markets. Invest regularly, and consistently. Properly allocate your investments to financial goals. Review your portfolio, only when it is necessary. Once or twice a year is sufficient.
Anchoring bias
Meaning:
Holding onto a past belief and then applying it as a subjective reference point for making future judgments and decisions is called “Anchoring bias”. Generally, what happens is, investors take a decision depending on the first source of information. For example, the earlier share price of a stock can influence buying and selling decisions.
If a share price of ABC stock is Rs. 500/- as of today, however, last year it was trading at Rs. 350/-. It does not mean that the stock is overvalued. Making a decision to buy that stock only when it again reaches Rs. 350/-, will not always help. Maybe you would lose a huge rally and you may not get it at the initial price.
How to deal with this?
Invest your time to do research and make a decision or it is a good idea to take help from a professional. Complete assessment of an asset’s price helps reduce anchoring bias. Be open-minded to new information — even if it is different from what you’ve initially learner.
Herd behavior bias
Meaning:
The most common bias in behavioral finance is ‘Herd behavior’. It happens when investors try to copy others rather than make their own decisions based on facts and figures. For example, if all your friends are investing in particular sector stocks, for example, ‘IT’, you might start investing in IT companies even though it’s risky.
It feels safer if we are not doing anything different. People feel safe when in a group and doing what others are doing. If your colleagues are making money investing in IT stocks, it feels uncomfortable to sit on the sidelines. Especially this bias is most common in beginners having no adequate knowledge about finance.
How to deal with this?
Give some time to yourself. Try to analyze your situation and then only invest accordingly. Research about a company’s fundamentals and see if it actually looks like a good investment. And be doubtful of hot stocks promoted on internet forums.
The financial takeaway:
The only way to protect yourself from all these biases is to know yourself. Be yourself.
Analyze your financial situation, assets, liabilities, risk profile, your financial goals, and then only invest accordingly. Take an informed decision.
To help you do this in a seamless manner, we have designed Tools which are available on our website.
Interestingly, being aware of these biases helps you avoid them. Having a “Financial Plan” in place, can help you make sound investment decisions.
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