Sound choice is in understanding the rules and mathematics of investment and shedding biases

Emotional biases are not related to conscious thought and stem from feelings or impulses or intuition, and as such they are more difficult to overcome

 “Ganit Nivesh Kaa Mushkil Nahin, Niyam Samajhanaa Bhi Hai Aasaan

Nivesh Falit Tabhi Hogaa, Jab Vyavhaarik Purvagrahon Se Ho Jaaye Traan.”

Translation: ‘Mathematics of investment is not difficult, neither are the investment rules;

Investment bears fruits when it is free from behavioral biases & prejudices.’

Morgan Housel, the celebrated author of ‘The Psychology of Money’ says, “You are not a spreadsheet. You are a person. A screwed up, emotional person.” And it’s truly so!

This gives rise to a separate branch of finance known as ‘Behavioural finance’. The study of behavioral biases is an important part of behavioural finance. An investor must get rid of these biases to make money from the capital market.

Let’s understand traditional finance and behavioural finances before proceeding further:

Traditional finance assumes that people are rational, risk-averse, and selfish utility maximizers, whereas behavioural finance is descriptive and focuses on how individuals actually behave and take decisions.

Behavioural finance recognises that the way information is presented can affect decision making leading to both emotional and cognitive biases. For example, there are two shops selling T-shirts. One person markets it as ‘buy 4 and get 25 per cent off’, whereas the other says ‘buy 3 and get one free’. Which will appeal you more?

Cognitive errors occur due to faulty reasoning, lack of understanding, information processing mistakes or memory errors. Such errors can often be minimized or mitigated with better training or information.

Emotional biases are not related to conscious thought and stem from feelings or impulses or intuition, and as such they are more difficult to overcome.

Let us try to understand some of these biases:

Confirmation bias: This occurs when people look for new information or distort new information to support existing views. Warren Buffet once said, “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”

Illusion of control bias: This happens when someone thinks he can control or affect the outcome which, in reality, he cannot. This is often associated with emotional bias: illusion of knowledge (belief you know things which you don’t know), self-attribution (belief you personally caused something to happen) and overconfidence (an unwarranted belief that you are correct). You will be hearing a number of such stories in the current bull run.

Hindsight bias: As the name suggests, this is a selective memory of past events, actions or what one was aware of in the past, resulting in an individual’s tendency to see things more predictable than they really are. This is typically the ‘I-knew-it-all-along’ phenomenon. A typical story could be that someone discussed a stock a month back and it turns out to be a multi-bagger.

Anchoring and adjustment bias: This occurs when an individual is forced to estimate unknown by often selecting an arbitrary initial value (the anchor) and then trying to adjust it up or down as they process information. There is bias towards interpreting other information around the anchor. Detection of this starts with asking a question like “Am I staying with the stock because I originally recommended it at a higher price?”

Mental accounting bias: This arises when money is treated differently depending on how it is categorized. This behaviour violates traditional finances assumption that the money is fungible. A typical example could be creating different folios for different investment objectives.

Framing bias: It occurs when decisions are affected by the way in which the question or data is framed. For example, a patient goes to one doctor who says, “you will need surgery but there are 10 per cent chances that you will still not get cured” and other doctor says “don’t worry we will do a surgery and there are 90 per cent chances that you will be fit and fine after surgery.” You can understand where this patient will go for treatment.

Availability bias: This is when one starts with putting more emphasis on information which is readily available. More recent events are easier to recall than events in distant past.

Loss aversion bias: This arises from feeling more pain from a loss than pleasure from an equal gain. Imagine a pleasure from winning Rs 10,000 in a day’s trade and pain from losing Rs 10,000 in a day’s trade. It is also observed that a person takes greater risk in investing this Rs 10,000, which he earned in a trade than Rs 10,000 that he will invest from his salary.

Self-control bias: This occurs when individuals lack self-discipline and prefer immediate gratification to long-term goals.

Status quo bias: This happens when comfort with existing situation leads to an unwillingness to make changes. Again, in the current bull run we can see some investors holding portfolios with inappropriate risk.

Endowment bias: This occurs when an asset is felt special and more valuable simply because it is already owned. Here examples could be investor’s holding things they are familiar with as it provides some intangible sense of comfort or failing to sell inappropriate asset resulting inappropriate asset allocation.

It is always good to understand the mathematics (valuation, earnings, growth) of investment, so is the rule (asset allocation, diversification, emergency fund). But before embarking upon the investment journey we should also ask ourselves questions like:

What are our biases? Are they primarily emotional or cognitive? How do they affect our portfolio asset allocation? And should these biases be moderated or adapted? Happy Investing!

(The writer is Executive Vice-president, SBI Funds Management Ltd; Translation and text by Niranjan Mujumdar, Vice-president and Regional Head, SBI Funds Management Limited)