Creating and managing a portfolio by the investor requires investment decisions to be made on which asset classes to invest in, how to invest, timing of entry & exits and review & rebalancing the portfolio. These decisions have to be based on the analysis of available information so that they reflect the expected performance and risks associated with the investment. Very often the decisions are influenced by behavioral biases, which lead to less than optimal choices being made. Some of the well documented biases that are observed in decision making are;
Greed and Fear
These are the most common biases impacting the retail investors. Investors enter the market when prices are already high and sell when the market bottoms out; thereby losing in both the scenarios and finally concluding “equity is the worst investment class”. Few who exercise patience overcomes these biases and emerges as winners.
Loss Aversion: The fear of losses leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure they felt at a gain of a similar magnitude. Investors prefer to do nothing despite information which may lead to a loss. Holding on to losing stocks are manifestations of this bias.
Over confidence Bias: Investors cultivate a belief that they have the ability to outperform the market based on few investing successes. Such winners may be the outcome of chance rather than skill. If investors do not recognize the bias, they will continue to make their decisions based on what they feel is right rather than on objective information and lose out in the long run.
Familiarity Bias: This bias leads investors to choose what they are comfortable with. This may be a familiar asset class, stocks or sectors that they have greater information about. Investors holding only real estate or a stock portfolio concentrated in shares of a particular company or sector are demonstrating this bias. Since other opportunities are not explored , the portfolio is not diversified enough to mitigate the risks of a concentrated portfolio.
Herd Mentality: This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction. Investing by taking tips comes under this bias.
Choice Paralysis: The availability of too many options for investment can lead to a situation of not wanting to make the decision. Too much of information also leads to a similar outcome on not taking action.
Sunk Cost:These are observed more in buying Insurance for investment. After paying premium for a long period, there is reluctance to discontinue the policy despite knowing that the return is very low. The selling agents exploit this bias by telling that the money already paid will be lost and advise not to discontinue the policy.
Individual investors can also reduce the effect of such biases by adopting a few techniques. As far as possible the focus should be on data and analysis. Adopting process-oriented investing and reviewing methods can help biases. Facility such as systematic investing (SIPs) will help. It is always good to have an adviser whom the investor can trust.