Human beings are wired to make decisions based on combination of logic and emotion.
Do you usually find yourself buying a large popcorn at a movie theatre?
When presented with two options, small and large popcorn, most people would choose what they need, which is usually the small size. However, when a medium-sized popcorn is introduced with a higher price than the small size but slightly lower than the large size, this can influence customer behaviour. The customer perceives the large size as a better deal, even if it's not practical for them.
This is just one example of how behaviour can be influenced. When it comes to investments or personal finance, our feelings and preconceived notions can also have a significant impact on decision-making. In this blog, we will explore the fascinating world of behavioural biases, including framing and recency bias, and discuss how they can affect our financial decision-making. We'll also provide tips on how to overcome these biases. So, let's delve into the intriguing world of human behaviour and money!
As it's quoted by Daniel Crosby:
“Human nature is both a miracle and a mess”
What are behavioural biases in investment decision-making?
When we make investment decisions, our emotions and thoughts can sometimes lead us to make choices that are not in our best interest. These emotions and thoughts are called biases, and they can prevent us from making good decisions for our money. Our brains are wired to find ways to simplify complex information, which can lead to biases in decision-making. This is why we tend to rely on mental shortcuts and rules of thumb when we make investment decisions, and more often than not, most of the investment decisions are driven by recent performance of the fund rather than thoroughly analysing all the parameters of the fund.
How does recency bias influence investors to favour recently outperforming investment schemes or asset classes?
1 year performance of equities and gold (In INR)
In the world of investing, it's common for investors to be drawn to assets that have recently performed well. This tendency is known as Recency Bias, and it's driven by the brain's natural inclination to take shortcuts when making decisions. For example, if we look at the performance of gold and equities over the past year, gold may seem like the better investment due to its recent outperformance.
Historical performance of equities and gold (In INR) since 1999
However, when we zoom out and look at the long-term performance of these asset classes since 1999, we can notice that equities have made a significantly higher return of 20x compared to gold's 14x return. This highlights the importance of taking a long-term view when investing and not being swayed by short-term performance.
It's also important to remember that diversification is key to building a well-rounded portfolio. Including different asset classes, such as gold, can help spread risk and potentially improve returns over the long run.
How can investors avoid recent events influence their investment decisions?
To overcome recency bias in investment decision-making:
· Focus on the fundamentals of the investment and its potential for long-term growth instead of short-term events.
· Avoid checking investment performance too frequently as this can lead to reactive and impulsive decision-making.
· Seek out alternative perspectives and opinions from trusted sources, such as financial advisors, fund managers, or experienced investors.
Shifting perspectives: How framing bias can impact investment decision-making?
A lot of people respond differently to the same information, depending on how it is presented. A classic real-life example can be seen in how people perceive the risk of a medical procedure based on how it is presented to them. For instance, a doctor may present a surgical procedure as having a 90% success rate or a 10% failure rate. While both of these statements convey the same information, they can have vastly different effects on the patient's perception of risk. The first statement may make the patient feel more confident about the procedure, while the second may cause them to feel more anxious or hesitant.
For instance, this happens in investing as well. Based on the chart below, do you think the recent fall in Nifty 50 index is the biggest fall in history?
Historical performance of Nifty 50 TR Index since 1999
A lot of people will say that yes, the Covid-19 drawdown was the steepest till now. However this is not true, this is merely due to an increase in the index that has enriched many investors over the years.
Highlighting drawdowns in the historical performance of Nifty 50 TR Index
This is a classic example of Framing Bias, when looked closely and calculated the actual drawdowns, the index corrected much more on percentage basis during GFC from Jan’08-Oct’08 (~-60%) and during the dot com bubble from Feb’00 to Sep’01 (~-51%) vs. Feb’20-Mar’20 (~-40%).
How to overcome framing bias while making investment decisions?
To overcome framing bias in investment decision-making:
· Focus on the actual data: When presented with investment information, focus on actual numbers and data rather than how the information is presented. Objectively analysing or calculating numbers will help investor to avoid getting swayed by how information is presented.
· Consider different perspectives: Try to view the investment opportunity from different perspectives to gain well-rounded understanding; this helps in avoiding making decisions based on single presentation or viewpoint.
· Seeking advice from a trusted financial advisor: A financial advisor can provide an outside perspective and help you make more informed decisions based on your individual financial goals and risk tolerance.
When making investment decisions, we should be mindful of our emotions and how they can affect our choices. It's important to focus on facts rather than the recent events or presentation of data. A systematic and rational approach to investing can help us overcome our biases. This approach involves conducting thorough research, diversifying our portfolio, and adhering to a long-term strategy. Ultimately, being aware of our biases, avoiding influence from recent events, presentation of data, and taking a methodical approach can help us make informed investment decisions.
Mahavir Kaswa is Head-Research of Passive Funds, Motilal Oswal Asset Management.
Source/Disclaimer: Marcellus investment managers newsletter, Niftyindices, CFA Institute, MOAMC Research. The above graph/table is used to explain the concept and is for illustration purpose only. It should not be used for development or implementation of any investment strategy. Sectors - Macro Economic Sectors as per AMFI Industry Classification. The stocks/sectors mentioned above are used to explain the concept and is for illustration purpose only and should not be used for development or implementation of an investment strategy. The stock may or may not be part of our portfolio/strategy/ schemes. It should not be construed as investment advice to any party. Past performance may or may not be sustained in future. This article has been issued based on internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The indices mentioned herein are for explaining the concept and shall not be construed as investment advice to any party. The information/data herein alone is not sufficient and should not be used for the development or implementation of any investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this article are as of date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken based on this article. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.