Good behaviour makes for better investing

Recognising behavioural biases and mitigating them can take you a long way in the investing journey



In the go-go days of early 2008, Kaushik Kumar (name changed) bought shares of Reliance Infrastructure at about ₹2,500 a piece — close to the stock’s peak price. But the global financial crisis soon hit, and the stock started tanking. Kaushik did nothing initially, hoping the fall was temporary. But with the slide continuing, he decided to average his cost by buying more shares on dips.

The stock went all the way down to ₹450 by March 2009. By this time, Kaushik’s average cost of acquisition had reduced to about ₹1,500 a share, but in the bargain, he had sunk in significant money into the stock. The stock never fully recovered and even now trades at just about ₹450. Kaushik eventually sold his holding in 2011, at about ₹700 a share — a sharp 50 per cent loss.

What made Kaushik put good money after bad, instead of selling and cutting losses early on? He was exhibiting a common behavioural investing bias – Loss Aversion.

Many investors tend to avoid losses to the extent possible. Understandably so; the pain of loss is said to be twice the pleasure of gain. This makes investors hold on to losers for too long in the hope of breaking even, and selling winners too quickly to book gains. Loss aversion, like many other behavioural biases, can be detrimental to your wealth. Recognising these biases and mitigating them can take you a long way in the investing journey.

The loss aversion bias, for instance, can be reduced by an objective, fundamental analysis of whether the investment and the valuation at which it is made, make sense, and by learning to overcome the mental pain of recognising loss. This will help base decisions on expectations rather than on past events.



Behavioural versus traditional finance



Behavioural finance recognises that investors, being human, do not always act rationally. It offers insights into how investors actually behave, given their many mental biases which leads to ‘bounded rationality’. This is unlike traditional finance that is based on the concept of the ‘rational economic man’ whose actions are unbiased.

Some of the world’s great investors such as Warren Buffet use behavioural finance to great effect in combination with traditional finance. Buffet’s famous maxim ‘be fearful when others are greedy and greedy when others are fearful’ is a key behavioural advice for successful investing that calls for contrarian thinking. Behavioural finance has been increasingly finding its place in the sun, with two Economics Nobels in recent years — to Daniel Kahneman in 2002 and Richard Thaler in 2017 — awarded for work in related fields.

Behavioural finance principles are relevant across market conditions. But they find more resonance in extreme markets — raging bull or bear — which induce severe bouts of greed or fear. Behavioural biases are of two types — cognitive and emotional. Cognitive biases (such as anchoring, confirmation) are caused by limitations of investors to process and analyse relevant information. Emotional biases (such as loss aversion, overconfidence) are caused by flaws in investors’ feelings and perceptions about information and decisions.

Based on experiences of a few investors (names changed), here’s a look at some key behavioural biases, and how you can guard against these.



Herding, recency bias



When the market crash of 2009 gave way to a strong recovery in 2010, a slew of initial public offers (IPOs) hit the market — a common phenomenon in bull runs. Retail investors lapped up these issues in droves, though many were quite pricey with risky business models. Listing gains on many IPOs buttressed this trend.

Arun Venkatesh, allured by the success stories and quick returns, latched on to the bandwagon, applied for and got shares in the public issues of Ramky Infrastructure (₹450 a share) and Oriental Green Power (₹47 a share). To his bad luck, the shares fell on listing day and continued their downward trend. Arun eventually sold these stocks at far lower prices — Ramky Infrastructure at ₹43 and Orient Green Power at ₹10 a share.

What is it? At play were a couple of behavioural biases — herding and recency effect. Herding is when investors tend to do what others in the group are doing — in this case, joining the bandwagon of IPO investors. Recency bias is giving more importance to events that have occurred recently as they are more easily recalled — in this case, the good listing gains on recent IPOs. These biases often cause investors a lot of harm. There is a good chance the majority could be wrong. Also, there is no guarantee recent events will continue; the tide could turn to your detriment.

Mitigator: Don’t follow the crowd blindly; make your own assessment based on relevant data and valuations. Evaluate events independently; don’t assume continuity. This is important now with many stocks trading at and several IPOs demanding very high valuations. A documented long-term investment strategy can help build suitable portfolios and stay the course without giving in to fads.



Overconfidence, self-attribution



With a fair understanding of investments, Sudha Mishra started dabbling in stocks in 2006, when the bull market was picking steam. With her first blue-chip buys, L&T and Tata Steel rallying sharply in a short time, Sudha became overconfident about her stock-picking abilities. She doubled down on the stocks and added riskier mid-cap and small-cap stocks to her portfolio. When the stocks continued going up, Sudha attributed it to her ability to pick right stocks. But when the market crashed a couple of years later and she lost heavily, she blamed everything except herself.

What is it? A rising tide lifts all boats, but many investors often overlook this. They tend to confuse luck for skill, take credit for gains, get overconfident and take risky bets which backfires when the tide turns. Blame is then sought to be shifted to external factors. Overconfident investors could underestimate risk and focus bets on limited stocks, increasing concentration risk.

Mitigator: Make an impartial assessment about the reasons for success or failure of an investment. Keep records, including reasons for investing, to help determine whether it was skill that generated gains or just plain luck that helped you ride the tide. Stay level-headed and desist from brash bets, just because you have tasted success.



Anchoring



Last year, Glen Castelino bought shares of GMR Infrastructure at about ₹11 a share. The stock doubled to ₹22 in June this year but has since then declined to about ₹17. When the stock hit ₹22, Glen thought of selling, but then decided to wait for further appreciation. Now that the stock is trading lower, Glen is waiting for it to go up again to at least ₹22 to sell. He is finding it difficult to sell at ₹17.

What is it? Glen is displaying anchoring bias. Investors sometimes get fixated to a particular value or price which acts as an anchor. Even when circumstances change, they find it difficult to reset this target number. This can be detrimental if the market cycle changes or the stock’s fortunes turn and the investor is worse off than before.

Mitigator: When the facts change, change your mind. Evaluate whether new information necessitates change in the target price. If yes, make adjustments. Fundamental analysis based on updated information and correct references can help.



Confirmation



Badri Naresh is eternally optimistic on the prospects of the Indian stock market. He thinks that the benchmark Sensex has only one to go — up — thanks to India’s demographic advantage and the economic potential in the country. Over the past few days, he has been pointing to Moody’s upgrade of India’s sovereign rating as a sign that the good times for the market will continue. Badri is dismissive of concerns such as expensive valuations and companies’ lacklustre earnings growth that could halt the party, at least in the near-term.

What is it? People have a tendency to see and hear what they want to see and hear. They focus on information that reinforces their beliefs while disregarding anything that counters their narrative. This confirmation bias can lead to risky choices such as buying more of existing stocks in the portfolio without adequate reasoning, and not paring exposures despite negative news.

Mitigator: Question your assumptions like you would of others. Seek out opinions that contradict your views and assess them for validity without bias. Be modest to acknowledge that you could be wrong and others right. Incorporate the correct inputs in decision making.

Besides the above, investors exhibit many other biases such as hindsight bias, endowment bias, mental accounting, framing, self-control, home bias and gambler’s fallacy (see graphics).

Emotional biases that are more hard-wired psychologically are tougher to mitigate than cognitive ones.

That said, a measured, logical approach to investing is the best counter to avoid investment pitfalls arising from behavioural biases.

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