Often, realisation dawns much later that these were bad calls. If only one could hold one’s nerves and not sell unduly for fear of losses! Being aware of loss aversion bias may help you take a more objective buy/sell/hold decision.
By Pankaj K Agarwal
Humans are creatures of emotion. As much as emotions make us more human, they may also cloud our judgment at crucial junctures; to our utter detriment. This is particularly true in the world of investing. Investment performance is not a function of just risk and return. The investor, nay, her temperament, is an equally important input to the final investment outcome. So much so, that legendary investor Warren Buffet once quipped: The chief enemy of the investor is the investor himself!
We list some key behavioural pitfalls every investor should guard against:
Our grief at losing something is far greater than our happiness at getting the same thing. A loss of Rs 10,000 hurts more than a gain of Rs 10,000 makes us happy. Insurance companies always knew this and therefore sell by evoking images of possible losses. Loss aversion kicks right in during bear markets. Investors tend to panic and sell otherwise solid stocks when these are falling sharply. Loss aversion also manifests itself in holding onto confirmed losers hoping for a rebound. Often, realisation dawns much later that these were bad calls. If only one could hold one’s nerves and not sell unduly for fear of losses! Being aware of loss aversion bias may help you take a more objective buy/sell/hold decision.
Who doesn’t like to be told how great one’s decision was or how clever one is to have invested in XYZ. We feel better when our choices are corroborated by others. But we all do that, I hear you say. Yes, and that’s not a problem. However, problem arises when we turn a blind eye to counterpoints in our quest for approval.
Sample this: You have invested in a mutual fund scheme after weeks of careful research. Then you come across solid arguments and facts that cast reasonable doubt on the scheme’s potential. But you ignore, and instead, hit the internet looking for pages eulogising the scheme. This behaviour is akin to seeking evidence after the conclusion has been made; and may prove a fatal investment folly. Remember; we all make investment misjudgments. Keep an open mind about your decisions and do not identify yourself with your investments. Shun your ego as it misleads you into believing you can’t go wrong. Course correct if necessary.
Studies have shown that in many instances, the entry/exit decisions of investors are determined by relatively recent out-/underperformance. We tend to project the most recent past into the future. This bias may be particularly damaging if you exit quality stocks in volatile times just because they fell recently. To immunise yourself from the consequences of this bias, hold back and try looking at the big picture whenever recent trends make you edgy or excited. Avoid checking your portfolio every so often. Refer back to why you had selected an investment and whether the logic still holds.
The demons in our mind are many more —overconfidence, availability heuristic, mental accounting, anchoring bias, etc. Being mindful of these behavioural patterns is the first step towards keeping your portfolio out of harm’s way. Unfortunately, no one else knows you better than yourself. But you can definitely help yourself by acknowledging which biases you are predisposed to. After all, the investor is her best investment friend too, isn’t it?
The writer is professor of finance, IMS Ghaziabad