Avoiding behavioural biases while investing
It’s ironic that while almost all the investments are designed rationally, majority of the decisions...
It’s ironic that while almost all the investments are designed rationally, majority of the decisions are made rather emotionally. This is where the science of behavioural finance comes into play. While all of the personal financial goals are derived out of dreams or aspirations, the approach or plan to achieve them are to be made rational. But, not always could we remain insulated to our feelings or emotions to judge or shortlist an avenue for investment. Some of the most common pitfalls and how to avoid are listed below:
Loss Aversion: Most of us are highly loss averse. For the same percentage of loss and gain, the emotions attached are not the same. Empirical data shows that losses are felt between two and two-a-half as strongly as gains. This means we’re hard wired to repulse losses of any kind.
The best way to avoid this fallacy is to have asset diversification and create a portfolio that suits the best. This way the overall risk to return on the investments could be minimized.
Emotional Bias: We respond more to our personality which is highly shaped up by our parents, upbringing and the environment we grew up. So, when we make any investment decision, we tend to focus upon how our parents responded to these situations and tend to react traditionally. This is exactly why we find that most of the investment products/solutions are marketed with an underlying emotional story. This behavioural trait could also influence the choice to opt in or opt out of an investment avenue from that of our earlier experience. This could lead to participating in an investment that wouldn’t suit the need though it could provide for better returns.
To avoid this mistake, one need to always look objectively at both the goal and the method to achieve it. It may, however, lead to a conclusion that makes one to invest in a completely new set of avenues to achieve the goal. Of course, it also requires one to accept changes in ones style of investment and also trust the advisor.
Herding: One size doesn’t fit all. This is the mantra in the investment world. So, a fund or an investment ones’ friend did wouldn’t always fit the other one. But, most often we tend to take reference from our friends to make an investment decision. Our past experiences mayn’t at all times turn soar but it’s important for one to avoid this common mistake. Though, it makes sense to take an reference to reach an advisor.
This common error could be avoided by evaluating the investment choices more closely and aligning them to ones need. This need based analysis and planning not only helps to avoid these hiccups but help focus and achieve the desired goals seamlessly.
Choice Paralysis: Ideally, the more choices we have the better. But, too many choices could lead to distraction and indecision due to information overload. This is especially when one scouts for the best possible choice leading to too much clutter to handle. It’s also possible when not much differentiation is available within the choices.
This could be avoided if the investor is clear on what one needs. Also, it’s important not to meddle with the advisor, at least, during the initial phases of recommendation.
(The author is a practising financial
planner and could be
reached at firstname.lastname@example.org)
By K Naresh Kumar