If you look at stock investing as an outsider, it looks attractive. The increasing stock price, the past returns, the bull run, and everything else makes you start your investment journey.
However, when you start investing, you tend to lose money, even in a bull market. Don’t feel let down, there are thousands of other investors who are in the same boat. Have you ever wondered why?
We tend to lose money or not make as much money as we should because of behavioural biases. Behavioural biases are preconceived notions that unconsciously affect our investing decisions.
If you don’t study and understand them, you are surely never going to overcome them. In this article, we will talk about some behavioural biases.
Overconfidence Bias – This bias is found in investors who are experienced and have made returns. Overconfidence has two layers to it – ‘I am making the right decision’ and ‘I have the correct information with me.’
Since you are overconfident on the above points, you tend to pick more stocks. The way you have gathered past information and made profits by using information makes you overconfident. You believe the same source and same approach will always give you returns. However, it is not the truth. As an investor, you continuously have to upgrade your skills, keep accumulating more knowledge and information. You cannot get overconfident about what you have achieved in the past.
Hindsight bias – Have you ever thought after reading about any past event – ‘I could have easily predicted it, how come most people do not see it coming?’
Today, many investors talk about Yes bank. They are confident that they could have predicted the fall before the fall. However, they fail to realize that information available today was not available before the event. If you think you could have predicted the Yes Bank fall or other similar events of the past, you have hindsight bias. In this, you tend to believe that you can predict future events as well. Hence, you start taking a lot more risk as you have a false sense of security. Sometimes, you will take more risks than you should have. You think before bad times come, you will know it before anyone and exit your positions.
Herd Mentality – If you invested in 10 stocks last year, try to figure out how many of them you picked because others were buying them or the news channels were talking about them? You will have a few on your list. The reason for it is because we have a herd mentality and tend to follow a trend. You make investments because others are investing in a particular stock or a sector.
For example, at present, everyone is talking about investing in an electric vehicle theme. If you go ahead and buy some electric vehicle stocks, you did so because of herd mentality. You need to understand EV is the future, and the returns will probably take time to come. Are you ready to hold on to your investment for that long?
You should not follow others as every investor has a unique investment journey. You should know your risk profile, investment horizon, investment style. Accordingly, invest in any stock.
Loss-Aversion Bias – Human psychology is that we hate losing more than we love winning, and this tendency gives rise to lose aversion bias. It means you will have more pain from the same magnitude of loss when compared to the same size gain. Hence, you will try to avoid losses, and you tend to become more conservative.
Let us understand this with an example. Let us assume you invested Rs 1000 each in two stocks. In the first investment, you made a Rs 700 profit. In the second investment, you made a loss of Rs 500. Will you be happy with your Rs 700 gain or sad for Rs 500 loss? Loss aversion bias says, investors tend to have more pain for loss than happiness for gains.
If you want to avoid this bias, you should stop looking at your individual investments. You should know that if you are investing in 10 stocks, two or three will not give returns or will give negative returns. Look at your complete portfolio while evaluating.
Recency Bias – Investors tend to weigh recent events more than earlier events. You shift your focus on investments that are doing well, completely ignoring the past data. For example, the small and mid-cap were giving exceptional returns to investors in 2017. It prompted many investors to enter the sector. Those who made entries after the returns were already 100-150%, soon felt the heat. The small and mid-cap corrected after the peak in January 2018 and remained sluggish for two years.
Such a mindset of investors where they think the recent or the current party will continue in the future also makes them lose their hard-earned money. Under recency bias, you don’t think about asset allocation or sector allocation. You only look at the recent market. If the small-cap is doing good, you tend to overweight your portfolio with a small-cap. The best way to avoid recency bias is to follow asset allocation.
Chasing past returns – Another common bias that adversely affects the investors. Studies have shown that investors tend to make investment decisions predominantly on the past year’s returns. Although they also know that past performance is not a reflection of future returns. Still, they tend to invest only by checking past performance.
You should check the past performance and read how the company has done in the past. It should not be the only criteria for investment.
Confirmation bias – Let us say you decide to invest in stock X for some reason – maybe your friend suggested, or you heard about it on some news channel. Under the confirmation bias, you tend to unconsciously seek information that supports your preconceived notions about an investment opportunity. So if you have decided to invest in stock X, you will overlook the obvious risks of investing in the stock and only read the information that supports your investment. It can also lead to overconfidence bias.
To ensure your investment decisions are not confirmation biased, you should gather all the information about the company and list both pros and cons. If you don’t find any cons, you are under confirmation bias.
Conclusion
You now know why investing is not easy and why so many people fail to make money. Overcoming these biases is possible. However, it is not easy.
Study your investment pattern and let us know which of the above bias have impacted your investment in the past. If you think it is difficult for you to overcome these biases, you can invest using JarvisInvest. It is an AI-driven investment platform that takes the emotion out of investing. Download our app now.