“How much money can you lose in the stock market?”
Last week, two young professionals, one aged 26 and the other 34, both working at the same company in the same city, with similar family backgrounds, came to seek investment advice. As we discussed stocks, bonds and mutual funds, I asked them that question, something I often ask young investors. The 26-year-old said, “Not much. Maybe 10-15 percent.” The 34-year-old said, far more emphatically, “A lot. Definitely 60-70 percent.” Why did they have two different answers to the same question? Simple. The 34-year-old’s tryst with equities started just before the global financial meltdown of 2008, and the 26-year-old started investing a few years ago.
The contrasting opinion of the two investors is largely because of a single experience, which caused a big difference in their way of thinking while making investment decisions. Neither is right or wrong, but both come with their own pre-conceived notions, or what you would call bias that influences their behaviour.
Behavioural bias is not just a complex-sounding investment theory, but a concept that has intrigued researchers around the world. Its core is very simple – we are human, just like these two investors, and because of our experiences, conditioning and personalities, we think in certain ways, follow certain non-existent thumb rules. Be it investing or life, biases always make us do things that are illogical and irrational. Today, we study five basic biases and how they influence mutual fund investing and, most importantly, what we can do to avoid them.
Anchoring Bias
We are shaped by beliefs, which we hold onto adamantly, and with age, we learn and unlearn them. However, for a few people, these beliefs are so strong, that they tend to filter any other view that doesn’t align with their ideas. In investing, the most common way an individual with an anchoring mindset thinks is to decide future return expectations based on past returns. For instance, investors who started an SIP in mid-caps in 2017 looking at 18 percent-plus annual returns, will invest assuming markets will do this consistently year on year, forgetting that a year like 2018 will come along when mid-caps will indeed fall. In fact, after this fall, the decision to hold the SIP should be driven by a rational assessment – “don’t stop SIPs at dips”, not because of an anchoring bias.
The best way to handle anchoring bias syndrome is to never let one factor – returns – drive your investment decision. The mind has a tendancy of getting anchored to it.
Always view returns as an outcome of an investment journey and not a decision-making driver.
The other trick is to avoid evaluating portfolios frequently, to tide through periods when returns are below expectations.
Loss Aversion
Loss aversion is that simple feeling of regret, after making a choice with a bad outcome, and we all want to avoid losses at any cost. Losing Rs 10 is twice more painful, psychologically, than the joy of gaining Rs 20 – on the same investment. This desire to avoid losses keeps investors away from investing in equities, and missing wealth creation opportunities.
It also keeps investors from exiting sub-par investments that are in the red, because we don’t want to realise the loss.
If you invest in a Rs 100 portfolio, Rs 20 should be divided into five different asset classes. Even if one or two have a bad run, the good outcome in the other few will preserve your peace of mind!
Also Read: How ‘Loss Aversion’ Affects Your Investments
Choice Paralysis
Today, we all are spoilt for choice, whether it is clothes, restaurants, phones or investments. Even worse is the fact that we are swamped with information through print, electronic and social media.
It’s time that we learn to say, “it’s enough!”. Excess of choice makes decision making difficult. In the world of mutual funds, if you are to do a simple one-time investment, you can get lost in an array of fund houses and schemes, for any goal or risk appetite. Finding the right scheme, if you are looking at that list, is a scary job! The way to avoid choice paralysis in mutual funds, as I often tell investors who ask me, “What is the best scheme to invest in?” is to start bottoms up, rather than attack 450 equity funds.
Understand your goals and then filter funds based on your investment objective and tenure, narrowing the universe to a limited number of funds that makes this selection task easier.
Recency Bias
We all remember the recent past rather than the actual past. In every bull market, we think of new highs and often increase our own risk-taking appetite, just because we feel bullish.
Also Read: India, A Nation Of Money Avoiders
With the onset of a bear market, reality dawns as net asset s fall. In investing, recency bias is prevalent especially in sectoral funds which investors often choose at their peak, only to have a bad experience after investing. The best way to avoid this bias is to avoid seasonal opportunities and stick to fundamentals.
Never forget to do a basic check on valuations versus historical levels, and then ask yourself the three reasons to invest in the fund – besides making a quick check on its past performance!
Herd Mentality
We love following what others are doing, so much so that if a lot of people are at a restaurant, visit a destination, or take a certain route, it’s usually considered a good one! Even if you don’t have a positive view on an investment, you are more likely to do it because of the herd. This ‘power-of-the-crowd’ mentality has created many a bubble in financial services, as markets run ahead of valuations because of the impact of flows and liquidity.
Theme-based investing in mutual funds, as well as a rush to risky asset classes like credit funds and small cap funds, are often herd mentality playing out, as people look at exemplary numbers with no reference to history or benchmarks. Herd mentality is the hardest bias to avoid, and the best way to avoid it is again fundamental analysis.
Ask difficult questions that no one is asking, and don’t invest till you find the answers!
Biases are inevitable hurdles in making decisions, and awareness of bias is an important step, a check box that you are not falling into a trap. A lot of time is often spent on “When do I invest?” and “What do I invest in?” Do the bias check – and ask a third question – “Why am I investing?”
Radhika Gupta is the Chief Executive Officer of Edelweiss Asset Management Ltd.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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