10 common behavioral biases that affect investment decisions

Many investors fail to take a disciplined approach to protecting and growing their finances due to certain biases. These biases lead to mistakes such as having inadequate or low life cover, avoiding or under-investing in equity-oriented investments, ignoring retirement planning and expose themselves to high-risk, unregulated investments.

This article points out such biases to help investors eliminate them and achieve effective wealth creation.

Fear bias/loss aversion

A large part of people do not dare to experiment, which is no different in the case of investmentsIn India, this is a monstrous truth that is easily explained by the single digit exposure to equity-oriented investments, despite them offering the best returns among asset classes over the long term. This fear originates from the conservative and traditional mindset of inability to digest capital erosion in a bad market.

In this case, lineage also plays a role, unless the person has the courage to break away from the conventional chain to experiment. The fear of being blamed by family for losses in bad markets could also reduce interest in venturing into actionsUnfortunately, only those who step out of this line of fear can create better and significantly greater wealth than those trapped in the shell of fear.

Greed bias

The desire for quick money often turns into quick poison when it comes to investments. Nowadays, many spoilers attract fans of quick money. F&O trading, online gaming and cryptocurrencies, which are a kind of gambling that triggers greed, have unfortunately caught a large number of subscribers by surprise in recent years. These avenues lead to unaffordable losses and, unfortunately, sometimes cost lives due to unbearable pressure and frustration.

The bitter truth about these avenues is that minuscule successes blindly motivate the addict to keep trying and unfortunately, most end up burning their fingers and money. SEBI’s report on 9 out of 10 F&O traders losing money explains this vividly.

Influence of community/herd mentality experience

The experience of parents, friends, relatives and community, both positively and negatively, influences investment decisions and can even form opinions on which asset class to adopt or avoid. This is just as ridiculous as the experience of an acquaintance who influences you may be due to the market period in which the investment was made or the choice of product. The outcome may be very different for you if you got these two factors right or wrong.

Moreover, what is suitable for A may not be suitable for B, as the risk profile may be completely different. The risk profile is not about income, financial assets, willingness to tolerate risk, knowledge of different investment products or age, but is a combination of all of these, the sum of which often varies from one person to another. Therefore, the influence of acquaintances or herd mentality is folly when it comes to investments.

Familiarity bias

Familiarity with products that are easy to understand or products that are consumed or followed in daily life, such as fixed deposits, gold, mutual funds and real estate, creates an impression in certain investors that only these are safe and better. Therefore, they tend to stay away from products that require intense analysis and understanding, such as equity mutual funds and stocks, even though they offer the best returns.

This fact is reflected in the single-digit exposure of Indians to stocks and equity mutual funds in general. This “frog in the well” mentality hampers wealth creation potential as the familiar products mentioned above hardly offer any real returns after the effect of inflation.

Guarantee bias

Guarantee is a big draw for most investors and they are attracted to products that offer a return guarantee such as Fixed depositsTraditional insurance plans, government savings schemes, etc. Investors miss out on the opportunity to realise that the assurance comes at the cost of a huge opportunity for return, and post-inflation, post-tax guaranteed return products leave virtually nothing on the table.

Market-oriented investments such as equity mutual funds and stocks, while they cannot guarantee returns, over the long term of more than seven years, they comfortably generate returns of 15-19% and with a minor tax impact. The comfort that a guarantee offers creates a great deal of discomfort in the process of wealth creation.

Recency bias

Recent memory and experience influence a large segment of investors, who tend to invest heavily in what has performed well recently. This can now be seen in a major way in mutual funds, where investors have been investing heavily in sector and thematic funds such as manufacturing, consumer and defence and small-cap funds. mid-cap funds that have performed well recently and allocating less to large-cap-oriented funds.

Late-stage players may have already lost steam, and sometimes it may be too late if one looks only at recent history without looking at the future scope. One case in recent history that investors should keep in mind is the kind of cash flow that the real estate sector experienced during 2014-2015, when the sector had been performing well for almost a decade.

But after this period of 2014-15, property prices barely budged and remained stagnant for more than 7 or 8 years until 2022, which is in fact a long period of negative returns, net of inflation. The situation is sad even for those who had bought a property on credit.

Bias towards hard/physical assets

There is also a common tendency towards hard or physical assets such as real estate and gold as the sense of tangibility gives a sense of satisfaction to touch and feel and people allocate more than is warranted to these assets. This is a misconception as investments are made to grow your money and not to actually touch and feel.

Investments in stocks, stock mutual funds, bonds, and even digital gold investments such as gold ETFs, gold funds, and U.S. Treasury bonds, which are held in electronic form, can be liquidated more easily than hard assets in an emergency. In fact, it can be unsafe to hold gold in physical form due to the risk of theft.

Influence of social media

Nowadays, the influence of social media on investment decisions is extremely high. A recent survey indicates that 2 out of 5 millennials’ goals are influenced by social media. When social media can influence even the goals set by the current generation, it is understandable to what extent they turn to it to make investment decisions.

While SEBI has issued robust guidelines for Financial influencersBut strict implementation of this is still far away. The sensitive and intensive topic of investment advice has been discussed by everyone on social media and investors, who are so biased that they blindly follow their suggestions, end up making wrong investment decisions by listening to them.

Past or initial experience bias

The first investment experience in a particular product forms a fixed opinion in the mind of the investor and very often that experience influences decisions about investing in the same product in the future. This is more applicable in the case of investments where returns are linked to the market and are not fixed. If the first experience was excellent due to good market conditions, the motivation to invest further is high and if the first experience was bad, they tend to avoid or resist investing the next time. However, this is not the right approach.

Whenever the choice of an action or stock mutual fund It is true that if you give your investment a longer period, it is more likely to yield good results. Mistakes from the first experience, such as choosing the right investment for your risk profile and investment horizon, can be corrected in subsequent attempts to improve and get good returns instead of getting carried away by the first experience.

At the same time, a great first experience also does not justify blind investment as overconfidence can cost you dearly. The first experience of mis-sold ULIP investments by investors before 2010 has left deep scars in their minds, leading to hatred towards the product in many. So much so that the word insurance itself has become unpalatable for many people.

Bias based on financial security and inadequacy

A person’s financial position also creates a bias in investment decisions. Those who are financially well off can take two extreme paths: being aggressive in investment decisions to multiply their profits, based on their financial worth, or being conservative or lazy in growing money because they don’t feel the need. Some of these wealthy people can also take the middle path. There is a particular bias that is very often seen among wealth investors when it comes to term insurance.

Most wealthy investors tend to ignore term insurance as they think that their wealth can more than protect their dependents in case of their absence. They fail to realize that a low-cost term insurance policy can keep their wealth intact and the amount insured can provide the necessary financial protection to their dependents. Wealthy investors mostly fall within the aggressive risk profile and hence can afford to make aggressive investments.

Similarly, the financially weak investors They also tend to take two extreme measures: either take an aggressive approach to grow money and create enough wealth or take a very conservative approach as they cannot afford to lose the little they have. These investors can also choose the middle path. Depending on their investment horizon and risk profile, these investors should make investments with an appropriate asset allocation.

Conclusion

Investors need to have long and in-depth contacts with investment experts, who can offer them professional advice to eliminate their biases and make informed investment decisions. wallets With an expert and the experience that can be gained over time, one becomes more mature in making unbiased investment decisions. Otherwise, biases can become major obstacles in the path of wealth creation.

V. Krishna Dassan, Director, Dhanavruksha Financial Services Pvt. Limited. Limited.