“When the heart speaks, the mind finds it indecent to object” feels author Milan Kundera. Yet, people like Warren Buffet, have followed their mind and won handsomely in the stock market. This is perhaps explained by William Blake’s statement “A fool does not see the same tree that a wise man sees”.
Conflict is a reality, it is all pervasive and touches human lives too. The perennial conflict of the mind and the heart often gives rise to a lot of dilemma. These conflicts are the mother of various behavioral patterns which cloud our decision making ability. We, as human beings are privileged to have a mind which can be applied to make intelligent decisions which are pragmatic and backed by evidence, yet we often choose to be driven by emotions. Our investment decisions are also affected by such biases.
Efficient market theory, is a theory which affirms that every stock in the market is priced according its actual value. All relevant information having an impact on its value are taken care of by the market mechanism and nothing is under or over-valued. If any aberration exists it is due to market inefficiencies.
Advocates of this theory use examples to prove their point. However, people like Warren Buffet, one of the most successful investors of all time, have consistently proved that by adopting value investing strategies, money can be made. So why are disciplined investors able to exploit down stocks consistently and make money, while a lot of others lose heavily? Well, it is because people are often driven by emotions and not by a logical mind. These are behavioral biases which cast a mist on the mind and four such biases are taken up for examination:
Larry Kersten advises “Before you attempt to beat the odds, be sure you could survive the odds beating you”. This is a useful and timely advice for those overconfident investors who feel that they can beat the market. Overconfidence has two closely linked facets, one is regarding the quality of the information and the other is about the timing of acting on such information for gain optimization.
Market history shows that overconfident investors fail more often than not and also miss out on the opportunity to appropriately diversify their portfolio. The underlying facts emerging from various studies point towards the fact that more active the investor the lesser money they make.
Trading less and invest more. Trading is a zero sum game. It rotates money; it is not generating money. The loss to a trader will be the profit to the other counter party trader. It is wrong to assume that individual intuition and information can beat the market. So resist such an urge.
This often happens with investors. They feel that they cannot go wrong, can never lose, and thus back a certain stock. Things do not work out as expected and at some point the stock begins to shed value. The investors still remain steadfast in their belief and refuses to sell. After some more time the share has lost a majority of its value.
At this point what emerges can be termed as “regret”. However, normal human psychology is to avoid a situation where they are filled with remorse or regret. The investor does not sell in order to avoid facing this feeling of regret. His investment sinks further and he still shies away from selling.
Cure: Instead of living with the non-performing loss-making investment, booking loss and reinvesting the money in better performing and profitable investment will increase the chances of recovery. “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks”- Warren Buffet
Limited Attention Span
The world is full of options, some lucrative, others not as much. However, in order to choose the coveted options is necessary to have knowledge about them. Most of the time people concentrate or look at only those options which they want to see. The half-knowledge that they gather serve as the basis for their investment decision thus making them flawed ab initio. Media driven information catches the attention of the investor while they miss out on potentially strong leads which are not covered as vigorously by the media. Half cooked food and half baked information can be harmful.
Cure: Learning to focus and undertake thorough analysis of the market in general and specific investments. A good and solid study will help yield opportunities to invest in stocks and mutual funds which are lesser known but have a lot of promise in delivering good returns.
It is like chasing a mirage in a desert. This happens to be the biggest behavioral bias that people are inflicted with. The disclaimer “past performance is not indicative of future results” often fail to deter investors from going ahead with stocks and mutual funds which have performed well in the past.
Investors who chase this mirage end up the poorest. Market dynamics are much more complicated and ever changing parameters ensure that the future is never the mirror of the past.
Cure: The best antidote to this bias is to follow “Buffettology” or the theory of Warren Buffet. Buy when the markets are low and sell when high. Judge the stocks on merit and act accordingly instead of taking decisions based only on past results.
Perhaps every investor has experienced some or all of the above biases. While it is not possible to wish away all behavioral biases, it is expected that the suggested tips will help mitigate their negative effects.
The author is Ramalingam.K an MBA (Finance) and certified financial planner. He is the Director & Chief Financial Planner of holistic investment planners (www.holisticinvestment.in) a firm that offers Financial Planning and Wealth Management. He Can be reached at firstname.lastname@example.org