What are Behavioural Biases and Why you need to know about it!
Before you start reading this article to know about Behavioural Biases, I would recommend you to read our introduction to Behavioural Investing by clicking here; to get an idea regarding what Behavioural Investing is and why it is important for you to know about it.
There must have been a time when the market didn’t perform according to your expectations. You were expecting something – but suddenly “Oh no! What did this happen?” moment might have occurred. Quite a while after this moment, on doing thorough retrospective analysis you may (or may not!) have understood where and how you went wrong. Things which might have seemed so obvious to you before now would’ve shown you a different perspective to look at them and suddenly it would all start making sense to you.
What happened in the above scenario?
Was your initial judgment about the market wrong? Did you miss something in your analysis? Or were you just being stupidly optimistic/pessimistic? One of the possibilities for your initial judgment being wrong could be your behavioural biases. A behavioural bias is an inherent belief or opinion (generally irrational!) that a person has about something, without any proof and justification for the same. It could severely impact your decision-making ability by giving them a tunnel vision; where you are unable to think about possibilities outside of the narrow scope limited by your behavioural bias; and all of this without you even knowing about it!
Therefore, you need to understand what your behavioural biases are and evaluate whether they actually make sense or are they just irrational thoughts which are clogging your vision about the market outcomes. The study of behavioural biases and how they affect investors in the market is one of the topics covered under the broader scope of Behavioural Finance.
In this article, we will go through some of the Behavioural Biases that commonly exist in people, so that you can ensure that none of these are impacting your decision-making ability.
Memory Bias (or Recency Effect)
As goes the famous phrase “Time heals everything”, it is a human tendency to forget things as time goes on. This results in one of the most common biases that exist in almost every human being, the Memory Bias. Simply put, it says that our mind focuses more on the recent events than it does on things that we’ve experienced or seen in the past. Whatever that has happened recently has a greater effect on how we perceive things, and hence we fail to see things in their totality.
This bias is so common that it even has large-scale impact on the overall stock market internationally. For instance, when the stock market crashed in 2008; all the investors were so pessimistic that the market fell far below what it fundamentally should have plummeted to. A few investors saw the opportunity, and realized that everyone is overreacting a little too much; and that the market will recover in some time. These people were the ones who didn’t follow the herd; they sold when others were buying, and bought when others were selling; and they are the ones who made a lot of money (some even enough to retire!).
So, whenever the market is experiencing a big change, and you’re feeling highly negative or positive about the market, the first question to ask yourself is – What does empirical evidence say? How has the market behaved when such scenarios happened in the past? Tell yourself that you should analyse the situation for what it really is than just going with what your gut tells you.
This is one of the most ironic biases that exist. Not all have it, but those who have it, find it extremely difficult to identify and accept it. However, this is also one of those biases that has the potential to cost an investor a lot of his wealth. It is definitely one to avoid, and you must always ask yourself if you’re affected by it or not.
How this bias culminates is when someone makes a sudden profit in the stock market out of pure luck, but confuses it to be their skill or talent, but not luck. It’s always good to be skilful and talented, however if your skill tells you to take a position without thoroughly evaluating a stock and its historical performance, then it’s your gut feeling – not skill; and you should take it for what it is. Maybe you were lucky once or twice, but relying on your luck under the pretext of skill is definitely a bad idea and should be avoided at any cost.
You may meet a big investor who is making moolah in the market by investing in all sorts of securities; and their personality and way of investing may influence you; but it doesn’t mean that you should blindly start copying their trades and whatever they’re doing. They might have a different financial position and an investment objective than you.
Herd mentality is when investors simply start copying other investors blindly without considering their own investment objectives and evaluation of the market and available stocks. It is important to acknowledge that your financial goal depends on a variety of factors like your age, assets, liabilities, income, etc. and is unique to you. It is not wrong to take inspiration from another investor and adopt their way of investing; but you shouldn’t end up copying their trades; without questioning what they are doing and whether it applies to your financial goal as well.
This is definitely one of the most interesting biases that exist; and today’s AI algorithms employed by all social media platforms are increasing this among the people today. Confirmation bias is when people try to seek out only information that confirms their pre-existing beliefs, instead of providing them an alternative way to think and question whether their beliefs are right or wrong.
The most important thing to know is that there are all kinds of information available in today’s world; there’s info to support what you believe and there’s also info to reject your beliefs. This is the reason why you need to understand that while you might be part of groups and social circles that share information which confirms the beliefs that you already have, it is equally important to also seek out news and information that challenges your beliefs and provides an alternate view of reality. This would make you see things from an unbiased and practical standpoint instead of being highly opinionated.
Framing is actually a technique that marketing agencies and media companies use; to show information in a way that works in their favor. It is important to realize that even facts are contextual; and you may not make the same decision if you were presented the same information in a different way. Therefore, whenever you’re reading a report or listening to your favourite investor, you should look at facts for what they actually are – instead of how they have been presented.
There are many behavioral biases that exist in different individuals; and it is extremely crucial for an investor to understand which behavioral bias they have. It is generally extremely difficult to identify your behavioral bias because they are so inherent; and embedded deep within your mind; that it becomes tough to think from an outside perspective and realize that your initial judgment was clouded.
As an investor, you need to overcome this clouded vision; once you’ve identified your inherent biases, you can make more rational decisions in the market by identifying early warning signals in the market; and not getting swayed by what the crowd is doing.
Hope you enjoyed reading this article! Please let me know your thoughts in the comments below.
Also, if you haven’t read already, you must read the introduction to Behavioral Finance here! It’s a small article so wouldn’t take much of your time.
You can read our other blog posts here.
Visit our YouTube channel for watching amazing videos on different topics in Finance & Investing strategies by clicking here!