Equity investing: Three behavioural biases to avoid when investing

January 20, 2021 12:45 AM

Portfolio performance tends to be poor when a majority of the buy and sell decisions are suboptimal because of irrational investing behaviour

One can learn to make better decisions.One can learn to make better decisions.

By P Saravanan & Manas Mayur

Over the last 30 years, the equity markets have performed extremely well but you may find that some segments of your portfolio have not done that well. One of the major reasons could probably be buying and selling shares at just about the worst possible point in time. Often, the majority of the buy and sell decisions prove to be suboptimal because of irrational behaviours. One can learn to make better decisions. Yes, it is not easy but it is possible. To become a successful investor, one should recognise and avoid the following behavioural biases.

Disposition effect
A common regret that most investors have is not holding some of the great stocks for long. Often Indian investors repent selling some of the multi-bagger stocks with very little gains. On the other hand, one may be holding value deteriorating stocks in plenty. This is popularly known as disposition effect wherein investors sell very quickly stocks whose value has increased since the time of purchase but hold on to their losing stocks. The reason for not selling loss making shares is that generally investors are hesitant to book loss. To overcome this tendency, it is very important that investors look at the quality of business before buying and selling and not get fixated on the stock price alone.

Anchoring
Another common mistake is comparing the current price of a share with its 52-week low or high price. Many investors buy stocks when the price is lower than its 52-week price as it appears too cheap. It did not take long for the investors to understand that they got trapped in bad stocks and that the free fall in the prices had solid reasons behind them. This tendency to rely too much on the recent or one piece of information available is called anchoring. Investors anchored to previous price levels to find a cheaper price; whether it is low as compared to its previous low or whether it is more expensive compared to its 52-week high. Investors must understand that the stock price reflects the fundamentals of the business and that the low or high price might have strong fundamental reasons behind that. It is not necessary that the stock is undervalued if it is close to its 52-week low or overvalued if it is near to its 52-week high.

Social proof
You should not buy shares just because your friend or colleagues are buying them. This tendency to take comfort in doing things which others are doing is called social proof. One of the common examples of social proof is online reviews or ratings which influences people’s decisions. We feel safe and certain if something is certified by many people. Rather, as an investor you should pay attention to the fundamentals of the company and how it will react to the external factors, instead of going by social proof alone.

To conclude, invariably every investor at some point of time has encountered the above biases. It is important to recognise such biases and deal with them appropriately to become a successful investor and get better returns on your portfolio.

Costly mistakes

  • Disposition effect is when investors sell very quickly stocks whose value has increased but hold on to their losing stocks because they do not want to book losses
  • Anchoring is another costly mistake when investors compare the current price of a share with its 52-week low or high price instead of realising the stock price reflects the fundamentals of the business
  • Social proof or tendency to take comfort in doing what friends are doing instead of paying attention to the fundamentals of the company can lead to wrong buy and sell decisions

P. Saravanan is professor of finance & accounting, IIM Tiruchirappalli.
Manas Mayur is associate professor, Goa Institute of Management, Goa

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