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Action that doesn’t have a logical reason and is unreasonable defines irrationality. But humans when it comes to investing, generally tend to exhibit or execute irrational behaviors than what was sorted out in the head as “Rational”. Do you relate to this? Irrationality is beyond your actions as it is influenced by emotion as well as cognitive biases.
Making rational decisions is all that we want while falling into the unpredictive-ness of our psychological ability makes it seem predictable sometimes. The most common irrational behavior so far accounted for is “Selling an investment after a moment it has lost the money”. Something that we all have done after the roller coaster of emotion that took place in the mind.
The Rational Investor Behaviour
They are the individuals who act in their self-interest. Those who make decisions based on the current data, i.e they are mostly well informed about the events and are convicted consistently. In simple words, “not following the crowd”. Ideally, they are rational.
But don’t you think it is a far-fetched scenario in the reality? If that were true, things would have been better!
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Coming Back to the Reality
The fact check is that we are humans and emotions come into play when we are making decisions and that influences the investments we make. After all, the investor doesn’t react to the losses and profits symmetrically. And most investors fall into the trap of behavioral biases.
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The Usual Behavioral Biases
While it’s true that the behavior of an investor matters a lot while investing, here are the common behavioral biases you might have come across.
Flashing News that Attracts
Let’s say there is flashing news on a particular stock on Twitter. That grabs the attention of any normal investor who would invest. That’s called “Attention Bias”. The negative consequences of the behavioral bias might have been visible to us commonly in instances like holding the losing stock for a longer time and in other ways, selling a winning stock too early.
Continuing to which losing the profits made with aggressive trading activity to cope with the losses can lead a green-looking portfolio to red in no time. Consider that definitely as an opportunity that’s never coming back to you. As it’s lost!
Regretting the Investments
Sometimes cognitive biases can as well be influenced by emotional biases in instances where you are an investor who hasn’t processed the information adequately and hop to make a decision influenced due to an emotional bias such as fear of regret. Fear of regret is one such bias where you are clinging to the mistake to your identity. That mistake reaps no benefit but yet you hold on to it.
The act of being overly Confident
An active and pro-investor can as well be a part of the behavioral bias. One such instance can be with “Overconfidence” and “Confirmation”. Let’s say you have a belief and some data validates only your belief though the evidence might show that it isn’t worth investing in. Yet because of the confirmation, they can take an investment decision due to “Confirmation bias”.
While on the other hand, sometimes people think that they know everything and might not know that they don’t know something are more “Overconfident” and can be influenced by “Overconfident Bias”. This might exclude the investors who are experts in the domain as they know their limits essentially to make such a fallacy.
Not Acting on Things Timely
Another pitfall can be then when you decide to buy something now and the option is commendable but you hold the purchase just so that you can find it at a better price. Thus missing out on a good opportunity when it actually was the right time to have taken a decision. This phenomenon is known as “Get even it is”.
In the financial aspect, it is like when the stock purchase was bad and yet you do not decide to sell it rather prefer to hold it waiting for break-even, or sometimes expect a trend reversal to take place and miss on the opportunity of selling it at a right time.
Being a Comforter
Let’s look into another scenario of “Familiarity Bias”. In this case, an investor usually tends to stick by the stocks that they are more familiar with than understanding the potential prospect of the stock that they are not familiar with. That’s more like being adjusted to drinking Cold Coffee because you are familiar with the taste rather than trying Smoothie which is a new thing.
Not Verifying but Acting Right Away
Moving ahead, have you come across an instance where you base your decision on the first judgment even though you can do a detailed analysis? Mostly while purchasing a shoe in an e-commerce store that is priced highly and is given at a discount which grabs your attention at a glance than having to check it at different places.
If you have to look into this aspect of finance then we all base the price of the stock as a benchmark while purchasing, but when a new stock is priced at the same price, it might look cheap. While in fact, it is not. But rather priced way too high if you analyze.
Being a Fortuneteller
Here’s another bias that might look like you are more familiar with. It’s “Hindsight Bias”. Funnily our mind is such that when the past predictions might have come true when we had predicted and base our future predictions like we can see the future of the stock ahead. The market can turn around on the flip side of your assumption and end up paying a loss that you didn’t see it coming.
Triggered by Loss than Gains
Here’s an interesting fact, “Investors tend to fear loss so much that they ignore the gains made.” That keeps their eye hooked on the “losing stock” consistently leading to selling a stock too early which was a winner and holding the losing stock for too long. That explains the “Loss Aversion” concept.
Mentally Accustomed to Rules
“Mental Accounting” is a bias we have been witnessing from parents since childhood. For instance, when you wanted your favorite toy and they denied to purchase saying a Big No. But while you wanted them to buy a book, they got you without a question. Don’t you see the money is spent based on some label?
If you think of this to an investor, then it’s more like thinking twice to invest money if it was from a savings account and not thinking even for a second if it was from a gift and waiting recklessly for profits or if it incurs a loss.
Gambler’s Attitude
Did you know Gamblers think of a series of events as a piece of Good or Bad luck based on the situation? While in reality nothing as such exists. Now think of an investor relying on the same fallacy and taking a move while there is absolutely no trend. It can cost big to them.
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Let’s learn a bit from Warren Buffet
He clearly stated that “Valuing is not the same as predicting” So then how do you price the stocks? Meaning an investment is done based on the logic that it would return a price that’s higher than what’s invested.
Any investor would usually ask 2 questions before investing:
- How much you’ll receive in return after investing?
- And how long will it take to receive those returns?
And he exclaims that the “Market is a voting machine in the short run, while it is a weighing machine in the long run.” Him having said that you must understand the intricacy of the problem at hand here.
The first big thing to know is that finance can answer the question of when will you receive returns depending on 2 things, “Interest Rate”, and “Borrowing Cost”
So here’s a thing you must know, interest rates keep changing. As you know it might rise or fall. When the prices are high the interest rates are low, and vice versa. Warren compared it to a thought of Aesop, “A bird in the hand is worth two in the bush.”
If the investor has invested in a stock that is pricey with low-interest rates, which means that they want the expensive birds in the bush in the hand though the returns are lower. But don’t realize they are paying prices that are shockingly high.
Necessarily it is sometimes better to have two birds in the bush itself and sometimes a bird in the hand.
While you are expecting returns from the market that is 10% and more then it is possible in 3 scenarios as he explains:
- When the interest rates fall and are below the historical value
- When the investors receive a share of the economy and it is above the high historic value.
- When the economy is drastically growing faster.
Basically, the stock market value reflects how the economy outputs.
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Conclusive Thoughts
There is always risk in predicting the future based on past results. And it becomes quite important for investors to understand that logic is not in the philosophy of believing that it is the next big thing, which is the “Hindsight Bias” and at the same time not knowing when to exit. It is neither in blindly investing in one sector like with the “familiarity bias” but in being a rational investor where you are logical and reasonable in any investment you do.
While the stock market can put you at the maximum risk and increase your mental stress, the bond market is comparatively much more tense-free while you are gaining a fixed income without having to keep an eye on the market.
