1: Loss Aversion Bias
We all hate losing more than we love winning. That’s because we don’t treat gains and losses in a linear way. And that’s what gives rise to the loss aversion bias. Now, loss aversion is the tendency to avoid loss over maximizing gains. Let’s look at this a bit deeper with an example. Consider two situations
Situation 1: While you are walking, you find a Rs 100 note lying on the ground. You pocket it and feel happy about it
Situation 2: While you are walking, you find a Rs 200 note lying on the ground. You pocket it and subsequently, someone picks your pocket and you lose Rs 100.
Which situation do you think will make you happier? The answer would be in Situation 1. Although you gained Rs. 100 in both cases, the emotional outcomes are different. A loss of Rs 100 gave you more pain than the gain of Rs 200.
We experience the same thing while investing. Consider the below scenarios
You invested Rs 1,000 and sold at a value of Rs 2,000. The same investment has touched a high of say Rs 3,000 and is now trading at say Rs 2,000. The pain from the notional loss of Rs 1,000 will be much more compared to the overall gain on the investment
This behavior is also evident from the fact that most people prefer Fixed Deposits even for long-term goals even though instruments like Mutual Funds although don’t have guaranteed returns, have a better ability to beat inflation over the long run.
Another aspect linked to the loss aversion bias is that be it pain or joy, we remember only extreme cases. We all prefer pain to be brief and joy to last longer. Let’s consider an example.
Imagine you are under medication and you get two options – an injection every day for the next 20 days Or an injection, which is 20% more painful, every day for the next 12 days
Most of you will prefer option 1, that’s because we tend to remember the intensity of the pain whereas the duration of the pain/joy is often ignored. Since under option 2, pain is 20% higher, we go for option 1.
Similarly, in investments, time correction does not affect emotions as much as price correction. We often remember negative events like “Black Mondays”, “Tragic Tuesdays”, etc. But often ignore the fact that a big fall in markets on a single day followed by a slow recovery is similar to markets staying flat over a year.
So now that you know what is loss aversion bias, let’s talk about how you should deal with it?
How to deal with loss aversion bias:
One of the easiest ways to avoid this bias is to adopt an overall portfolio perspective and not look at investments individually. Different asset classes perform differently at a time, so if you have a well-diversified portfolio spread across asset classes, you will have some investments underperforming while others performing well. And hence on an overall portfolio level, you will not see extreme losses or volatility.
Also, it is important to remain aware of loss aversion as a potential weakness in your investing decisions.
#2. Herd Mentality Bias
It is the phenomenon where we follow what others are doing rather than charting our own path. This behavior is often driven by the fear of missing out.
All of us want to become rich quickly. When the markets are on their way up, seeing quick gains being made by others around is a trigger for most us to act. After all, we want to avoid the feeling of being left out or left behind when everyone around us is making money. And we chase returns by following the herd.
But if you follow this, you usually end up with a portfolio that is riskier and may not be appropriate for your risk appetite. The outcome has always been a disappointment in terms of returns.
A classic example of herd behavior occurred in the late 1990s. Investors followed the crowd and invested in stocks of IT companies, even though many of them were loss-making and were. Herd mentality was again seen in 2007-08. In both these instances and other examples of herd mentality, it is often the case that investors’ confidence level peaks with market levels, and as a result, the largest chunk of money gets invested almost at the peak of the cycle. And you know what comes after peak – a fall.
So if you follow the herd you are almost guaranteed to be left disappointed.
How do we deal with herd mentality bias:
Two words – Asset Allocation. Asset classes move in cycles and no single asset class continues to outperform or underperform. Over the last 20 fiscal years, equities, debt, and gold have outperformed each other at different times. So, build a portfolio with an allocation to each asset class. How much you should put in each depends upon your risk appetite but once you decide stick to it.
Asset allocation also ensures you do the opposite of what the herd is doing. Here is how – as one asset class starts performing, let’s say equity, the percentage allocation of equity in your portfolio will start going up. So, to bring back the asset allocation mix to the original level, you will have to sell part of equity investments. So you book profits while others invest trying to get returns you would have already made.
#3: Mental Accounting Bias
Although behavioral biases like herd mentality and loss aversion are often talked about, mental account bias doesn’t get much attention.
Mental accounting, a behavioral economics concept introduced in 1999 by Nobel Prize-winning economist Richard Thaler, refers to different values people place on money, based on subjective criteria, that often have detrimental results.
In simple words, we treat money from one source as more important than another. This behavior is also experienced while investing and can make you take illogical decisions.
Let’s take an example. Sanjeev is a salaried person and works hard to earn his monthly income. One day he gets news that one of his uncles has died and that he has left him a huge amount of money. Now since this money came not from his hard work, Sanjeev will be more likely to be okay taking risks with it. That’s because there is an emotional attachment with his hard-earned money and not with these gains.
Now you might say, I am not like Sanjeev but think about it. How many times have you stopped yourself from investing a larger part of your salary in equities since you perceive it as a risky asset class and don’t want to lose your hard-earned money? But if you get some money you didn’t expect coming your way, you will be more open to taking risks with it.
There are tons of other examples too. For instance, treating tax refunds as windfalls and using it for buying something. Even the habit of treating yearly bonuses differently to monthly salary and spending it lavishly is an example of this bias.
How should you deal with mental accounting bias:
The best way, which actually helps you use this bias to your advantage, is following a goal-based investment approach. Once you attach a goal to a particular investment, you mentally allocate that money to a particular purpose.
#4: Availability Bias
Availability bias is a mental shortcut that relies heavily on information that is easily available or places undue emphasis on immediate examples. It is the human tendency to think of events that come readily to mind; thus making such events more representative than is actually the case. Naturally, things that are most memorable, come to our mind most quickly. We tend to remember vivid events like plane crashes and lottery wins, leading some of us to overestimate the likelihood that our plane will crash or, more optimistically that we will win the lottery.
A study showed that people are more likely to purchase insurance to protect themselves after experiencing a natural disaster than they are to purchase insurance before such a disaster happens. Similarly, in investments, negative events that have led to severe market corrections are always at the top of the investor’s minds. However, investors tend to ignore market performance post the sharp correction.
For instance, in 2008, the markets crashed and the US S&P 500 index fell 37%. But, the following year, in 2009, the market bounced back with a return of 26.5%. After 2009 ended, a survey was conducted asking people how they thought the market performed that year. Likely due to the traumatic events of the recent crisis, two-thirds of respondents incorrectly thought the market was down or flat in 2009.
There are far too many examples – Dotcom burst, the 2004 crash after the formation of new Government, the Global Financial Crisis, Greece Sovereign Crisis, Chinese devaluation in 2015.
All this leads us to believe that the risk is more than it actually is and we make errors like not having the right asset allocation or not diversifying our investment enough.
How do you deal with availability bias:
Well, you need to look past all the noise and then act. For instance, we are experiencing an unprecedented scenario with Covid-19 and its impact is being felt across the globe. But before you stop investing or even redeeming, ask yourself, will Covid-19 grab headlines one year from now like the way it is doing now?
Sure, market corrections hurt. But after every fall comes the rise and if you want to make the most when the markets bounce back, then look at the fall as an investment opportunity and not a reason to exit.
#5: Recency Bias
Recency Bias is our tendency to weigh recent events more heavily than earlier events.
We often overemphasize more recent events than those in the near or distant past and shift our focus towards the asset class in favor of today. For instance, in 2017-18, there was euphoria in the mid and small-cap space. Looking at the returns of the last couple of years, investors, irrespective of their risk appetite, invested heavily in the mid and small-cap funds even as space got overheated. And then came the crash.
This tendency to think that the recent experience will continue into the future usually leads to disastrous consequences. That’s because if you get swayed by a recent event, you will either go overweight or underweight in the asset class which is in favor or out of favor, thus leading to inappropriate asset allocation. The overall risk in the portfolio also increases drastically as you will, in all probability swing your portfolio to extremes during such situations, with the hope that the trend will continue in future
How do you deal with recency bias:
The first thing you need to do is accept that lane changing i.e. looking at the recent track record of returns to keep changing which fund or which asset class you invest, doesn’t work. An asset class performing well today might not do well tomorrow.
And secondly have an asset allocation strategy and stick to it.
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