The Psychology of Investing: Unveiling Behavioral Biases and Making Smarter Choices
Tuesday, Apr 9, 2024
We think we all are capable of rationalism, all the time—but we’re not. When was the last time you felt hungry and couldn’t decide what exactly to eat, or knew that an important deadline was approaching but still decided to continue the social media scroll? The issue isn’t really about whether we’re capable of being rational or not. Humans are extremely complex beings who psychologically react and respond to multiple forms of stimuli, millions of times in a day.
‘Bias’ simply means an unconscious inclination towards something. It’s like having a preset notion that something/someone is better, without objective reasoning, often based on flawed logic or irrational assertions. One might undermine the Indian filter coffee as subpar compared to Italian cappuccinos when a comprehensive review of lakhs of ratings globally by Tasteatlas shows that it ranks second globally only behind the Cuban coffee drink “Cafe Cubano”
That’s enough about coffee, but surely such biases are strictly non-existent in the world of finance. Business, economy, and governments are the epitome of rules and order, right?
Well, not quite.
Time and time after, we observe the market being excited and afraid. More often than not, it rallies continuously upward and sometimes the other way around for seemingly no reason. If we want to comprehend market reactions from a psychological standpoint, we need to understand the critical blocks that make up behavioral finance.
Essentially, comprehend ‘biases’ and how they affect people and trigger rapid market fluctuations.
Biases To Be Aware Of.
- Overconfidence Bias
“You constantly try to predict fluctuations and reinforce your predicting abilities within yourself. Over time, believing that you’re never wrong”
If you’re actively involved in the finance markets, without realizing it, you might develop notions solely on the basis of your observations. Over time, some patterns might recur and you pick up on them and end up thinking that you now know something that nobody else does. This sense of blatant irrational confidence can lead you to make bold predictions and take up decisions that you normally and objectively wouldn't. You might end up taking on bets excessively.
- Loss Aversion Bias
“You hate being in the red zone—so much so that you just can't wait to get out of the position. Rather than being patient to pursue potential gains, you're happier that you aren't at a loss”
While studying behavioral finance, Daniel Kahneman and Amos Tversky suggested in their ‘Prospect Theory’, that losses and gains, though opposites on paper, were asymmetrical in people’s minds. Investor value gains less than when they avert loss. Another way of looking at it is–-that people feel greater pain when they incur losses than the excitement and pleasure that they would get from potential gains. This asymmetry leads to investors exiting from great positions very quickly, thereby missing out on all the potential gains.
- Herd Mentality Bias
“If your favorite finfluencer talks about a 'hot-new' investment opportunity, you're quick to follow suit—without really thinking through it on your own”
While we think we know what we know, it’s crucial to know what we don’t too. Just because someone is doing something that you don’t understand, doesn’t mean that you need to blindly trust others' instincts. Following someone and engaging with them to understand and obtain new knowledge is one thing, but blindly making committal moves with your real capital solely on somebody’s advice—having the mindset of “because everybody is doing it” will cause you to be in a regrettable stance later on.
- Confirmation Bias
“You have a notion, say, “real estate is going down”, you would look up information about real estate investments and only process the information that matches the pre-existing notion that exists in your mind. Any contrarian perspective—no matter how really true—is not objectively considered by you”
If you’ve ever seen people trying to search YouTube in between an argument, congratulations, you’ve been in the presence of someone who operates with this bias. That's because YouTube is not a reliable source. You can find “evidence” of aliens and that the earth is flat on there. If you choose to believe the unverified, unchecked unsolicited opinion of someone, to confirm your beliefs on a subject—you’re essentially cherry-picking information that supports what you already think. This tunnel vision prevents you from considering alternative viewpoints or critically evaluating the validity of your beliefs. As a result, you end up reinforcing your existing beliefs, regardless of whether they're accurate or not, leading to a skewed perception of reality. This is an extremely dangerous bias to have.
- Anchoring Bias
“Being fixated on a piece of information and trying to correlate everything else on its basis.”
Let’s assume you’ve been following your favorite stock in the market for a while now. You see that it’s performed exceptionally well in the past month with its high being ₹1250 and is currently priced at ₹1000. From that point of view, you think that if the stock dropped 20%, i.e., if it comes down to ₹800, it would be an awesome price to buy considering its performance. You forget about it for a couple of months now. Later, you find that the same stock is now at ₹800—the price you wanted—and you blindly buy it as you’re still of the notion that you’ve bagged an awesome stock for cheap. Since you were anchored into thinking that for a particular stock, you miss the broader picture—that the market was bullish back then and now has entered the bearish realm. The price continues to collapse and you have willingly entered a lost position.
- Availability Bias
“Out of sight, out of mind…but in sight, all over the mind!”
Have you ever thought that billboards are stupid? I mean, why would someone care about a jewelry brand while driving on a highway? Well, it just comes down to spreading a sense of familiarity. The more times you see a particular brand—when it comes to choosing between the one brand that you’ve been exposed to and the one you haven’t—the obvious choice would be the one that you’re familiar with. The information that you needed to make the choice was readily available to you in your mind and because of the availability bias, you're indirectly biased towards the brand that you've seen or heard before. While the unknown seems sketchy, the known seems trustworthy.
- Regret Aversion Bias
“You're standing at a crossroads, unable to choose a direction, because you're terrified of making a wrong decision. ”
This can also be thought of as an inability to make a decision. You consider every investment vehicle like mutual funds, bonds, equity, crypto, and real estate, and you just can't seem to find what you want to invest in. There's an inherent sense of fear that whatever choice you make will turn out to be the wrong one and you will end up regretting it. Instead of being decisive and taking action to move forward, you remain in a state of analysis paralysis. The fear of regret holds you back from being rational about investments in general and traps you in a cycle of indecision.
- Fear of Missing Out (FOMO)
“Feeling pressured into taking action over speculation and uncertainty—because everybody else is talking about it.”
FOMO makes people and the markets behave in ways that should theoretically be possible. Amidst the crypto bubble, a significant amount of venture capital flowed into crypto businesses with unproven business models. This caused a vicious cycle which led to the crypto tokens rapidly gaining momentum. People were afraid of missing out on the opportunity to get rich quickly, so they rushed into investing without fully understanding the risks. This influx of capital drove the crypto markets to astronomical heights purely based on hype and not the fundamental value of the asset. Ultimately, the retail investors who joined the rally without understanding anything were left with worthless investments.
How Can You Stay Objective?
It seems like we’re always in control of our minds. But the reality is that we’re not. We’re easily manipulated. Finding ways to stay objective and rational about portfolio management and capital investments is crucial for financial well-being. Failure to do so might eradicate the gains earned over decades in one biased decision. For a retail investor, this seems too much. It’s almost impossible not to react when the markets move. We at Green Portfolio understand this and provide PMS portfolio management services, wherein you will be getting advanced guidance from seasoned finance experts.
Be aware and vigilant.
This doesn’t mean getting a degree in finance or learning about complex financial analysis. It just means you are aware of the rudimentary construct of the world of finance and economics in general. Learning about how things are connected on the macro and micro scale will outright make you an informed investor. Know about the psychological tendencies and spot them while you make financial decisions. If you struggle with managing your investments amidst market chaos, click here to hear from one of the best PMS service providers in India.
Stick to the basics
The basics are real. Fundamental objectives are achievable. Rather than falling into a hype cycle, follow the basic rules of investing. Before making any investments, learn about the companies you want to invest in. Do you understand what they do? Evaluate their financial history and projections. Do a thorough analysis of their current market positioning and growth prospects. Invest once you’re certain and don’t look back. A -5% return in the short term should not cause you any significant emotional reaction because of your research!
Systematic Rebalancing
Evaluate the status of your portfolio quarterly or semi-annually depending on your goals. The more aggressive you are in your investment style, the shorter the rebalancing timeline should be. While the markets are at an all-time high, it’s important to strategize defense for the impending short-term downfall and build up cash reserves to capitalize while the markets have hit the lower circuit. Green Portfolio PMS service providers in India are a research boutique that caters to informed investors who want to collaborate with leading financial analysts to get an edge over the market.
Playing the Long Game.
Decide on your objectives beforehand. If you want to build wealth long-term, then the short-term fluctuations shouldn’t concern you. Having the vision to stay focussed on setting objectives for the long term is crucial for investors who are serious about portfolio management and building wealth. Don’t panic when you read a concerning headline. Take a step back and reevaluate your strategy. You can always balance your portfolio the way you like. Wealth building is a game of endurance and dedication. Strategizing wealth-building is tough. It requires an overall understanding of the world of finance and in-depth knowledge of every investment mode and its impact on the portfolio. Green Portfolio provides PMS services where they take care of the entire strategy end-to-end so that you don’t have to. Instead, you get to learn and grow by collaborating with our committed finance experts.
Reflections
Being conscious and alive means much more than being logical. We’re also sentient beings who care deeply. While it’s our tendency to view the universe through an emotional filter, wealth building requires nerves of steel, faith in financial fundamentals, and endurance.
Discipline is key:
- While you watch two finance experts and hosting finance journalists battling it out in a TV show with contrarian perspectives; listen and analyze viewpoints. Don’t actively react.
- Say no to the “hot stocks” on the market. Diversify instead.
- Stay proactive. Have an active game plan for your investment at all times. Don’t react to market movements.
- While finfluencers have unique, catchy, and clickbaity things to say about the stock market, don’t herd along. Take advice from trusted financial professionals and do your own research before making investment decisions.
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