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Behavioral Finance Finance

Behavioral Finance Series Part II

Part I gave a good introduction to what Behavioural Finance ACTUALLY is. As a recap, Behavioural Biases can be divided into TWO categories namely, (I) Cognitive Errors and (II) Emotional Biases.

In this post, let’s delve deeper and understand what our “Emotional Biases” are shall we?

EMOTIONAL BIASES

Emotional Biases are the types of behavioural biases driven by errors in our thought-process and intuition. Therefore they are called emotional biases. It can be categorised as follows:

  1. Loss Aversion
  2. Over-Confidence Bias
  3. Self Control Bias
  4. Status Quo
  5. Endowment Bias
  6. Regret Aversion

LOSS AVERSION:

Let’s say you lose a 1000 bucks. If you experience greater pain for the loss of the 1000 bucks as compared to the joy you’d feel if you received the same amount, that’s called loss aversion. Basically, when we place greater value on the loss of the investment relative to us gaining an equivalent amount.

As a consequence, investors tend to:

(a) Hold onto bad investments for far too long in order to avoid realising the loss.

(b) Sell investments too quick, in order to realise small-gains because they fear making a loss.

How do we overcome Loss-Aversion?

Emotional biases are harder to correct as compared to Cognitive Errors. However, by being mindful of their decision-making process Investors can substantially reduce the impact of such emotion-driven biases. By maintaining a disciplined investment philosophy, a well-thought out investment process and by focusing on the future prospects of Gains/Losses objectively, investors can avert the impact of Loss-Aversion.

OVERCONFIDENCE BIAS

Investors, sometimes tend to be overly-confident about their investment calls. The reason for this can be many; if an investor has heavily researched a particular basket of stocks and made the right-calls in previous occasions, he/she might start believing that they are capable of correctly predicting the future price movements with high precision (Wolf of Wall Street moment?). While in reality, it can very well be the case that the former favourable price-judgements might have been attributed factors external to the investor’s own knowledge.

How do we tackle Overconfidence Bias?

The investor should keep track of the investments made for the past 2-3 years and perform a thorough attribution analysis. This would help the investor objectively determine what percentage of the investment decisions made and thereby favourable outcomes observed could be attributed to “luck” or to a “disciplined decision-making” approach.

SELF-CONTROL

Investors are sometimes prone to selling-off investments too quick in order to reap immediate gains (thereby falling prey to instant gratification). Without considering the hyperbolic-discounting they are applying to their otherwise valuable investments. This could also be the other way round, wherein investors sell good-quality stocks way too early in order to close out on small-losses rather than wait out the longer run to reap the actual intrinsic value.

How do we overcome Self-Control Bias?

Self-Control Bias, is something most of us would be especially prone to (remember the last time you binge-watched an ENTIRE Netflix series?). From an Investor’s perspective one way to curb this would be to follow a disciplined Asset-Allocation process and have a systematic plan to fund their savings account.

STATUS QUO EFFECT

Displaying the status quo bias, would essentially mean you’re the couch potato of investors! Overlooking good investment opportunities, unwilling to change current investment allocation regardless of changing economic scenarios and thereby over-hold investments for way too long.

How do we overcome Status-Quo Effect?

This bias, is especially hard to overcome as human beings find it exceptionally hard to think beyond the “Status-Quo”. One way this bias could be ameliorated is by educating oneself and other investors about the various risk-return combinations that exist for changing socio-economic circumstances. Along with having a well-defined methodology for portfolio rebalancing.

ENDOWMENT EFFECT

When investors place a higher value on the stocks/assets they own as compared to the price they would pay to purchase that very asset themselves, is called “Endowment-Effect”. What we own, usually seems more valuable to us. This is usually heightened, when the assets are an inheritance or a gift. This is a special type of the status-quo bias, leading to investors to hold-on to assets for far too long for emotional reasons.

How do we overcome Endowment Effect?

In order to prevent over-concentration of the portfolio and an ill-balanced position, investors can choose to replace their holdings step-by-step in order to decrease the pain of detachment from their loved asset positions.

REGRET-AVERSION

Also popularly known as the “fear-of-missing-out”. Regret Aversion leads to herd-like behaviour amongst investors, leading to over-purchasing of overpriced assets which might not really be worth their buck!

How do we overcome Regret-Aversion?

Well, we’ve all been a victim to this bias at some point in our lives for sure! But as an investor, the best way to remain cognisant of “FOMO” is through constant education of the benefits of diversification and maintenance of a disciplined investment philosophy.

CONCLUSION

Biases are not totally random and are in fact very systematic and predictable. Contrary to what Traditional Finance states, individuals don’t always make rational decisions, don’t posses perfect information and aren’t always Utility Maximising (we don’t always act out of self-interest, we can be pizza-sharing angels sometimes 🙂 ). We’re not anything like the “Rational Economic Man” in reality and we rely on heuristics, mental-shortcuts and intuition to make decisions.

However, by educating ourselves of the possible behavioural biases we might fall victim to, we can more decisively and mindfully navigate the world of investment management!

And that’s a wrap for this week! 🙂 Stay tuned for new articles every week, simplifying Finance for Gen A to Z.

Happy Learning,

Prarthana Shetty

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