Section 17 – Behavioral Bias In Investment Decision Making

Table of Contents

Behavioral Bias in Investment Decision Making

An investor needs to make many decisions when it comes to investment, like –

  • which asset class to invest in
  • how to invest
  • timing entry and exit
  • reviewing and rebalancing portfolio

These decisions must be taken by analysing –

  • expected performance of the investment
  • risk associated with the investment

However, often what happens is that the investor takes his decision not by careful analysis of relevant information, but based on his behavioural bias like confidence bias, herd mentality, choice paralysis etc. These are discussed below – 

Optimism/ Confidence Bias

  • Investors acquire confidence and believe they can continuously outperform the market based only on some success.

Familiarity Bias

  • Investors invest only in those stocks and sectors with which they are familiar and have more information.

Anchoring

  • Investors continue to rely on old information which is no longer relevant for decision making. They dismiss the new information as irrelevant. e.g., an investor waiting for the right price to sell, even when new information suggests otherwise.

Loss Aversion

  • Fear of loss of money holds back a lot of potential investors.
  • Sometimes, an investor also continues to hold on stocks which are not expected to perform well in future, just so they don’t have to sell them for a loss in the present.
  • If investors feel that there is a possibility of loss in short-term then they prefer to do nothing, even if taking the risk might lead to gains in the future.

Herd Mentality

  • Some investors believe that others have better information and tend to follow others investment decisions.
  • This leads to a lot of investors entering the market when it is already overheated and poised for correction. Herd mentality also leads to creation of bubble in the market.

Recency Bias

  • People take recent events and extrapolate them to predict future.
  • If there was a crash in the market some time ago, people place their money in safe assets. If there was a bull market, people place their money in risky assets even when the sound investment advice is suggesting otherwise.

Choice Paralysis

  • If there are too many investment options or too much information available, then the investor might feel overwhelmed and do nothing.

These behavioral biases also contribute to the wrong decisions while considering Mutual Fund Investments and hence must be avoided to take rational and wise investment decisions.

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