“The investor’s chief problem, and even his worst enemy, is likely to be himself.” – Benjamin Graham. Investing has always been a tricky business, hasn’t it? Just last week, one of my friends invested in stock because its name matched her initials, and another time, one of my uncles bought twenty-one shares of a twenty-one-year-old company, on his son’s twenty first birthday, they didn’t have a logic behind it, they just believed it would be lucky for them, and it happens to the best of us. When it comes to financial decision making, we might end up being biased in our approach to investing in the right stocks.
Let’s look at some of the most common biases in behavioral finance.
- Endowment Effect
Each of us will always have one special object so inculcated with emotional meaning and nostalgia that no amount of persuasion could ever convince us to give it up. Our XBox, or that 10-year-old t-shirt, or our FRIENDS DVD box set, we can’t dream of giving up these things. We are endowed with these things.
This feeling of ownership towards material belongings is known as the ‘Endowment Effect’, it affects financial decision making, and it has long been the subject of study among psychologists and marketers.
Once we receive something, it becomes ours, and more often than not we get attached to it. Once it is ours, letting go of it feels like a loss, even if it is a burden for us. Many times investors hold on to a ‘losing’ stock rather than get rid of it because they are constantly expecting a miracle, a turnaround that may never come, and they’re just building up their losses. This effect is similar to ‘loss-aversion’ bias, according to which people believe what they own is more valuable than it actually is.
- Sunk cost fallacy
Let’s say you’re at a theatre watching a movie, and ten-minutes in you realize that it’s terrible, but you still stay for the whole movie, because you paid for it, and even if you leave you aren’t getting any money back. This is a classic example of the sunken cost fallacy.
It happens when an investor puts more money in a losing investment because of previous reasons. The more money you put in a corporation, the harder it becomes to abandon it, and slowly, it just becomes a cycle. This is an emotional dilemma wherein it becomes difficult to walk away from a failing investment because of the time and energy already put into it. Thus, the sunk cost fallacy is an error in reasoning in the sunk costs of an investment are fully taken into account when deciding whether to continue with the investment.
- Bandwagon Effect
Remember when you started using fanny packs, or the crocs, or any other fashion trends that you really weren’t keen about, this is known as the ‘Bandwagon effect’, and all of us have fallen for it, whether we consciously know it or not. This effect occurs when people start mimicking the buying choices of other people. For many marketers, this phenomenon when put into action can boost the popularity of a certain stock or a product, straight into a grand slam. This effect influences investor behavior even when a stock/product has features they don’t need, or even understand.
I am sure you must know about the ‘dot-com bubble’ which burst in the beginning of this century is a typical example of herd behavior, wherein people blindly started investing in dot-com companies, when they didn’t even understand the behind-the-scenes of it, just because everyone was doing it, and they wanted to get in.
- Familiarity Bias
If asked, wouldn’t you be more willing to invest in companies that you buy products from, or where you work, or where you have a family connection, because you seem to trust them. This is known as the ‘familiarity bias’. It is the inclination to remain close to what is familiar to them, and believe more in the choice that they recognize and are aware of, because unfamiliarity makes them unsure and uneasy.
This bias puts off the investors from analysing the genuine potential of the lesser acknowledged companies and stocks, that may actually turn out to be more profitable than the common options they always choose to look at.
- Anchoring Bias
Let’s say, you went shopping, and you saw the price of a shirt to be Rs. 2000 in one store, and Rs. 900 in another, and this makes the latter option seem cheap. The higher cost in your anchor price, this technique is often used by retailers to use a higher list price for their products on ‘sale’ at Rs. 4000 with a 75% markdown to Rs. 1000.
Investors often tend to base their decisions on the first source of information they receive (like the initial purchase of a stock), and later might have a difficulty adapting their views to new information. Traders lean towards holding onto a belief and then apply it as a subjective reference point for financial decision making.
- Gambler’s Fallacy
Suppose you are asked to toss a coin multiple times, and a ‘head’ occurs the first five times, most people would then be inclined to believe that a ‘tail’ is likely to occur the next time, arguing that the repeated occurrence of ‘heads’ increases the likelihood of a ‘tails’ outcome. Gambler’s fallacy is a phenomenon named after gamblers who believe that a string of good luck will follow a string of bad luck.
Gambler’s fallacy lies in seeing arrangements where none exist, investors often feel the need to impose a sense of order on things that are actually random, just to make sense of them, and to feel in control. This bias can often give rise to unfounded credibility to the claims of fund managers who have been earning good money for a few years in a row, and hinder their financial decision making.
These are just a few cognitive biases that hinder financial decision-making, and it is important to be careful while taking such decisions, navigate these biases in effective ways; wealth managers who understand these biases and their consequences are often the best choice when it comes to financial decision making for your investment portfolios.