A Primer on Behavioural Biases that Drive Investor Decisions

Behavioural bias is classified as any irrational belief or behaviour which tends to have a direct bearing on the overall decision-making process while investing.

Generally, behavioural biases are categorised as emotional and cognitive biases.

Emotional biases relate to making decisions based on one’s feelings rather than looking at concrete facts. On the other hand, cognitive biases are errors in the thinking process while interpreting information that is directly available.

A few of the behavioural biases in investing are as below:

Overconfidence: Having a certain level of confidence is definitely good, no doubt. But then placing too much confidence to overestimate the outcomes of investment decisions leads an investor on a sure-shot route to poor portfolio performance.

Apart from adding potentially uncalled-for risk to the investment portfolio, an investor’s overconfidence may expose them to higher relative costs, which are commonly associated with the frequent buying and selling of assets.

Anchoring: When an investor relies heavily on a single or first piece of information or experience from the past to make investment decisions, it is referred to as anchoring or focalism.

Typically, such bias is likely to occur in cases where an investor focuses more on unwarranted details, which ultimately lead to error in investment decisions. Anchoring bias could have an influence on investment patterns and lead an investor to zero in on sub-optimal decisions with regard to their investment portfolio.

Representativeness: An investor may draw a conclusion on the basis of the fact that suggests (represent) it rather than trying to delve deeper into it or undertaking a thorough analysis further.

Representative bias is likely to lead to making sudden judgements considering a situation’s similarities to an earlier matter in the past.

Loss aversion: It relates to an investor’s instinct to be influenced by the overpowering fear of loss and trying to avoid it rather than looking at the positives of profits. This could lead to adopting a risk-averse behaviour.

There could be several reasons behind loss aversion bias, which could be caused by a variety of psychological, social, cultural, and market factors.

Regret avoidance: When an investor refuses to take any decision because of the fear that the decision will turn out to be wrong and then may later lead to feelings of regret, such a behavioural bias is referred to as regret avoidance or regret aversion. The emotional process behind this is quite simple, that is regret leads to emotional pain. Therefore, the brain tries to avoid making decisions that lead to regret.

This could lead investors to stick to poor investments for too long or to continue adding money in the futile hope that the situation will turn around and losses can be recovered, this way avoiding any feelings of regret.

Frame dependence: Also referred to as framing, this bias means that the way an investor responds to situations depends on how the situation is framed or presented, rather than on the actual facts of the situation. Simply put, while taking investment decisions, investors are usually more influenced by how the information is presented rather than what information is presented.

Herd-mentality bias: An investor may be carried away by the tendency to follow and copy other investors rather than conducting their own analysis independently. In a herd behaviour mentality, a significant number of individuals act in the same manner at the same time. In the equity markets, herd mentality is to be found in the form of volatility. The prices suddenly rise or fall because a large number of traders or investors try to enter or exit the market at the same time.

As a general rule, an investor should rely on facts instead of being directly influenced by recent developments or turn of events. A systematic investing approach based on one’s thorough research while diversifying portfolio on a regular basis and staying focused on the long-term horizon can be considerably useful for an investor.