Can we free ourselves from biases in investing decisions? Becoming conscious of them this Independence Day can help

The pricing of equity requires the weighing of the long-term prospects of the organization represented by the stocks. Therefore, it seems rational to speculate that investors’ emotions and perceptions do influence the price of a stock. Two different persons may have different viewpoints on the prospects of the business.

Although the investors are recommended to look at the fundamentals of the stocks while designing or executing their trading strategies, they lack either the sophistication or the time or the bandwidth to check the fundamentals before making any buying or selling decision in equity. Since the investors possess bounded rationality, they make decisions under the cognitive limitations of their mind and the time available to make a decision that may be a satisfactory solution rather than an optimal one.

In recent years, two areas of stock market research have gained traction on investor decision-making strategies. The first area of interest covers mood misattribution which includes biases and the impact of certain environmental factors such as weather, the body’s bio-rhythms, social factors, and most importantly, the investor psychology on equity pricing. The second field of research explores the influence of the stock image on investor decision-making, the theory being that the image of stock triggers investor emotions that drive their investment actions in part. The behavioral biases affecting investors’ decision-making process are as follows:

1.??????Overconfidence: Overconfidence in investors may result in excessive or active trading, which can lead to underperformance. The least active traders had an annual portfolio return of 18.5 percent in a 1999 report, versus the 11.4 percent return experienced by the most active traders.

2.??????Loss Aversion: ?When asked to choose between receiving $900 or taking a 90% chance of winning $1000, most people avoid the risk and take the $900. This is even though the expected outcome is the same in both cases. Also, if the stock in which an investor has invested is constantly dropping, it is very difficult for the investor to take a call for going short under the fear of getting loss.

3.??????Convenience Bias: This is based on the familiarity bias of an investor. Investors prefer to invest in "familiar" investments of their own country, region, state, or company. Although the best practice is for portfolios to hold at least 300 stocks, the average investor only holds three or four.

4.??????Gambler’s Fallacy: When asked to choose which is more likely to occur when a coin is tossed—HHHTTT or HTHTTH—most people erroneously believe that the second sequence is more likely. The human mind seeks patterns and is quick to perceive causality in events.

5.??????Attention Bias:?A study posits that individual investors are more likely to buy rather than sell those stocks that catch their attention. For example, when Maria Bartiromo mentions a stock during the Midday Call on CNBC, volume in the stock increases nearly five-fold a few minutes after the mention.

6.??????The illusion of Control: This bias can make the investors trade more than the judicious amount of a particular stock in the market, and take aggressive long or short calls. Sometimes, investors may use limit orders to experience a spurious sense of control over their investments. It may also make the investors make more concentrated and less diversified portfolios.

7.??????Anchoring: The investors are also prone to the anchoring effect. This means that they may be heavily dependent upon the value of a stock communicated to them at the beginning of the decision-making process. After that, any price lower than the anchor may seem reasonable to the investor, no matter even if it is still over-priced.

8.??????Framing effect: Investors tend to perceive investment performance based on how it is presented. This can be gotten rid of by avoiding the focus on unrealized gains and unrealized losses, and considering the prospects irrespective of whether the stock has gained or lost in the short term.

9.??????Hot Cognition: It is often observed that the decisions of investors are influenced by their mental state. The same investor may feel risk-averse at a particular moment of time or risk-prone at another moment.

10.??Status quo bias: This is generally discovered when the investors do not change their strategies with time and continue to use the earlier trading strategies or maintain the existing portfolio even when it may make sense to revise it with the changing dynamics of time.

11.??Sunk cost bias: When the investor sees the unrealized losses on the earlier investments as the sunk cost, one may be willing to wait more and more for them to rebound and for the sunk cost to be recovered, losing time value of money as well.

12.??Cognitive Dissonance: Sometimes, the inconsistency between the investment decisions and the investment beliefs of an investor may make him or her seek comfort by avoiding new information or explaining away one’s decisions. This can prevent the investor from correcting one’s wrong decisions and thus, detrimental to the wealth of the investor.

13.??Bandwagon Effect: Investors tend to follow the herd or to think the way the other investors are thinking. It requires a very strong sense of conviction to resist this tendency. Many of the financial crises such as the Dotcom Crash of 2000 or the sub-prime crisis of 2008 can be attributed to this bias.

14.??Hindsight Bias: We would have observed that investors often convince themselves after the market has experienced something that they had predicted it accurately before it happened. This makes them infer that they have the ability to predict other events as well and become over-confident.

15.??Disposition Effect: Often, investors have been observed to hold on to the stocks that have significantly fallen in value, while holding on to the stocks that have increased in value.

16.??Endowment Effect: It is difficult for investors to sell the already owned stocks as compared to acquiring the same stocks when they do not own them. They would avoid selling the stocks at a price and try to retain them, while also trying to avoid buying the new stocks at the same price.

17.??Self-attribution Bias: Investors tend to attribute their successful decisions to their ability to think well, while they may attribute the wrong decisions to situational factors or the misadvice by others. This bias prevents investors from correcting their flawed approach and learning from their mistakes.

18.??Trend-chasing Bias: Investors find it simplifying to believe that whatever has happened in the past is going to happen in the future. This prevents them from looking at the realities of the present business scenario and evolving the strategies accordingly.

19.??Recency Bias: Investors get more influenced by recent happenings. For example, it is difficult for them to believe that the stock market is recovering after a trough. Similarly, it takes time for them to recognize that the market is falling after a peak.

20.??Worry: Anxiety is one of the most basic biases that make investors make sub-optimal investing decisions.

It has been observed that the demographic characteristics and culture in a region are also a determinant of how prone is an investor to biases. Therefore, it is the need of the hour for the investors to exercise caution while making the decisions. Investing in equities and stepping into the stock market in general needs a risk appetite for an investor over one’s investment horizon. There exist a few ways by which investors can reduce cognitive biases. If retail investors acknowledge the social influences on their investment behavior, they can minimize the chance of being affected by the decision-making process of professional investors who dominate the pricing of large stocks.

Disclaimer: Kindly note that the views presented in this article are your personal opinions of the author and are not affiliated with any particular organization.