Stock markets are considered to be efficient in pricing the assets at all times. The efficient market hypothesis states that all the information related to a certain stock is already known to everyone & hence, priced in the current market price of the stock. However, there are buyers & sellers at each price in the stock market. So, if everyone has the same information, then everyone should make the same decision. But that's not always the case with stock markets.
Humans are complex & irrational. The human brain is designed to process a large amount of information quickly and efficiently, which is necessary for survival. However, this can lead to certain cognitive shortcuts or heuristics, which can create biases.
Regardless of how disciplined, people often make financial decisions that are coloured by behavioural biases that cause them to act on emotion or make mistakes processing information.
One reason for behavioural biases is that people tend to rely on their past experiences and memories to make decisions. For example, if someone has had a positive experience with a certain investment in the past, they may be more likely to invest in it again, regardless of the current market conditions.
In this article, we are going to discuss about the 7 common biases faced by individual investors that can impact their investment decisions.
1) Confirmation bias: This is the tendency to seek out and give more weight to information that confirms one's existing beliefs and to ignore the information that contradicts those beliefs. Example: Investor may ignore the latest adverse information about the stock that he is holding which may differ from his existing belief about the stock.
2) Anchoring bias: Anchoring bias is the tendency to rely too much on the first piece of information that is received when making decisions. This can lead to overvaluing or undervaluing investments. Example: While selecting a stock to invest, an investor often checks its 52-week low price. This is the initial information that gets into his mind and may act as an anchor in making his investment decision. A stock at 52-week low price doesn't really mean it is cheap or investment worthy as the investor might perceive it.
3) Herd mentality: The tendency to follow the actions of others without considering one's own research and analysis. This can lead to buying overvalued assets or selling undervalued assets. Example: Investors may buy a certain stock because a big fund manager or a big investor has bought the stock in their portfolio. It is important to understand the rationale behind the big investor's decision rather than blindly following it.
4) Mental accounting: Mental accounting is the tendency to treat money differently based on its source or intended use, rather than treating all money as equal. This can lead to poor investment decisions. Example: A person who wins a huge sum in lottery may think of it as free money and not use it prudently as he uses the money earned from his regular sources. This happens a lot when someone makes large profit on a single trade & bets it on a much risker trade.
5) Recency bias: This is the tendency to give more weight to recent events and to assume that they will continue to occur in the future. This can lead to overreacting to short-term market fluctuations and making impulsive investment decisions. This is different from confirmation bias where the recent information that confirms the existing belief is weighed more than the information that contradicts it. In case of recency bias, there is no existing belief.
6) Hindsight bias: Hindsight bias is psychological phenomena where an investor is convinced that he predicted an event long before it occurred. This can be seen where people claim they saw everything in advance with respect to companies going bankrupt and markets crashing. The problem with such bias is it causes overconfidence in ones ability to predict future. This could work both ways.
Example: Let us assume that you have a stock in your watchlist and think it is undervalued and should go up. But you still don't act on it. This could lead to frustration when the stock goes back up as you had predicted it. Investors should be careful in evaluating their own abilities to predict the current events and their impact on portfolio. Such bias can easily lead to overconfidence and sub optimal returns.
7) Sunk Cost Fallacy: This is a behavioral bias that acts as a roadblock when we have invested a lot of money into a stock. The price becomes a reason to carry on even when we have lost the confidence in the investment. Example: Investor buys a stock at Rs. 100 and now the stock is trading at Rs. 10. The current market price makes him anxious to hold it until it recovers back to the old price. This is irrational thinking. The purchase price of stock should not play a role in deciding whether to sell the stock or hold. If the fundamentals have worsened then it shouldn't matter at what price the stock was bought.
It is important to check if any of the above biases is letting you hold on to a certain investment even when the actual information states otherwise.
Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited