During an informal discussion on the stock market during a birthday party a few years ago, an investor sought my opinion about a stock, which he was holding for a long. Since that highly leveraged company was heading for difficult times, I suggested selling the stock and buying a pharma stock whose fortunes were improving. But this investor was not convinced. He said, “I don’t book losses. I am prepared to wait till the situation improves.” To cut a long story short, the stock crashed since then and the company has gone bankrupt.
Accepting pain is difficult. The human mind is conditioned to avoid pain. But accepting the inevitable pain and cutting losses is hugely important in investment. Economic theory assumes ‘consumer rationality’, that is, human beings are assumed to act rationally to maximize satisfaction when they spend money. Similarly, investors are assumed to behave rationally to maximize returns from investment. However, reality can be very different. Emotional and irrational decisions can lead to sub-optimal returns, sometimes to disastrous results. This is the reason why Behavioral Finance is gaining popularity as an emerging subject. Let us look at some important biases in investing.
Loss-aversion bias
The instance quoted at the beginning of this article is a classic example of loss-aversion bias. Retail investors are more prone to this bias. I have come across many retail investor portfolios holding stocks such as Reliance Communication, J P Associates, Suzlon Energy, GVK Power and similar stocks, which have been steadily going down for many years now. Refusal to book losses has cost these investors dear.
Endowment bias
It is human nature to give high value to something that we own. A stock that a person owns is regarded as undervalued by the owner. She doesn’t sell it even if it is overvalued. Psychological tests have shown that people judge things objectively when they don’t own them. The tendency to attribute a higher value to stocks that investors own can turn out to be an emotional error.
Herd instinct or Bandwagon effect
Herd instinct is a strong emotion in stock market. Many retail investors, particularly newbies, move with the herd. They irrationally jump on to the bandwagon everyone is riding. Stocks are bought on tips and rumors without any research or homework. When too many investors jump on to a bandwagon that becomes a popular fad and can turn out to be a bubble, which will eventually burst. The tech bubble which burst in 2000, leading to one of the worst stock market crashes in history and global recession, is a classic example of herd instinct bias.
Self-attribution bias
As the saying goes, “success has many fathers, failure is an orphan.” When investors become successful with a stock they attribute it to their stock-picking skills. But, when they lose money, they attribute it to bad luck or circumstances beyond their control. This bias can cloud rational decision-making. The fact is that luck and unexpected factors play an important role in investment success. Millions of investors have become rich in the ongoing bull market, which began after the market crash of March 2020. An important contributory factor to this rally is the ultra-loose monetary policy followed by the leading central banks of the world, particularly the Fed. But many
investors who have benefitted from this rally attribute their success to their smart investment decision, often ignoring the role of money printing by the Fed in this ‘asset price inflation.’
Recency bias
Sometimes wrong decision-making arises out of preoccupation with the recent past ignoring the lessons from the distant past. If the market has done well in the recent past, many investors believe that it will continue to do well. Similarly, if an industry has done well in the recent past, they expect it to do well in the future too. Many newbie investors who have started trading/investing in the market after the crash of March 2020 are not aware of the bubbles that led to the market crashes of 2008 or 2000. Their focus is on the recent past and, therefore, they ignore many risks associated with bull markets. This ‘irrational exuberance’ may end in pain. A related bias is Coattail investing where investors cling on to the coattail of some famous investors. They buy a stock because a famous investor has bought that stock. This is risky because investors may not have complete information about the strategy of the famous successful investors. He might have moved out of the stock by the time the retail investor buys the stock.
Therefore, it is important to appreciate the fact that successful investment is not about number crunching alone. Investors have to overcome the many emotional biases that can cloud intelligent investing.
