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Four biases to avoid in today’s market conditions

Hari Viswanath |BL Research Bureau | Updated on: May 14, 2022

Being aware of your biases will help you become a better investor. Here’s how.

Since the time benchmark indices hit a peak in October last year, markets have been gyrating up and down, and making almost anyone’s prediction (bull or bear) come true for a short period of time.

As volatility drags on, unless you are cautious in ensuring objectivity in decision-making when it comes to investments, you can be caught completely on the wrong foot when the market begins to decisively move in one direction at some point in time.

In their pioneering research in the 1970s, which laid the foundation for deeper studies in behavioural finance, Nobel Laureate Daniel Kahneman and his research partner Amos Tversky first provided insights on what drives poor decision-making. According to them, decision-making is plagued with ‘coginitive bias’ — limitation in objective thinking that is caused by the tendency for the human brain to perceive information through a filter of personal experiences and preferences.

Today, the topic of cognitive human bias is an extensively well-researched subject and there is overwhelming evidence of how this plays out in our everyday decisions. Investment decisions are no exception. While luck might eclipse a poor investment decision and make it appear as an excellent one in a shorter time-frame, it definitely wears off over time. Being aware of your biases will help you assess your true investment skills and tell you how you must invest based on your temperament. 

Here we discuss few biases and how to address them.

Hot Hand Fallacy

After a batsman has hit two consecutive fours, you are tempted to think the next ball is also likely to cross the boundary. Imagine what you are likely to think after many years in which stocks outperformed fixed income? It is natural to believe stocks will continue to outperform fixed income.

This is one cognitive bias common in human beings called the ‘hot hand fallacy’. This bias is a result of extrapolating past trends to the future. We have seen this consistently play out over the last one year with earlier repeated comments from global central bankers that ‘inflation is transitory’ when there was evidence to the contrary. Their view then was based on trends observed over the last decade where inflation turned out to be elusive in developed markets. However, this view has turned out to be wrong now.

Similarly bias was prevalent in the domestic front when it came to market predictions. It was not uncommon to hear, last year, frequent sound bites on where Nifty and Sensex will be by 2025 or 2030. However, those noises have been on the decline in recent months, as unfavourable global macros and geopolitics have threatened the assumptions based on which those targets were built.

The problem here is not in the events that have transpired since those calls were made, but is that of those giving aggressive predictions and forecasts, being in the grip of hot hand fallacy. To unbiased observers, risk of inflation and Russia-Ukraine crisis existed even before start of 2022, many of which are well documented and available in public.

How to address

The way to address hot hand fallacy and guard against its pitfalls is to take a fresh look at fundamentals at frequent intervals. Historically and fundamentally, there is overwhelming evidence of money printing and loose monetary policies being followed by high inflation. That inflation was subdued from the time of financial crisis to the time of Covid was not sufficient period to conclude that centuries of correlation between money supply and prices has been altered permanently.

When it comes to stocks, mean reversionis common and one must always factor for the same before every single investment decision.

Loss Aversion

According to the concept of loss aversion, a widely-prevalent cognitive human bias, the pain of losing is psychologically about twice as powerful as the pleasure of gaining. This plays out so frequently amongst stock investors where one prefers to holding on to a stock at a loss and averaging it to recover the cost of investment at some time in future. This is as opposed to consider shifting to another stock that has better potential to give sufficient gains to make up for the loss. There might also be times when booking losses and shifting to cash or other asset classes might be the best option if the market cycle is to turn adverse for a longer period.

With decision making sometimes impaired due to impact of losses, investors tend to think a stock, which they originally purchased in triple digits, is attractive when it has fallen to double digits and attempt to average aggressively. However, stocks can further fall to single digits and can later get de-listed or go bankrupt as well. Buying in triple digits, averaging in double digits and being forced to sell in single digits is not uncommon in investing. This played out in many sham IT companies during the dotcom boom and bust, many real estate and infra companies during housing boom and consequent financial crisis in 2008. This may play out now for many companies/stocks that partied in the last two years mainly on liquidity and sentiment, with very little fundamentals to support. Thus, the bias of loss aversion is one of the most crucial biases to be wary of.

How to address

Equity is a  risk instrument and thus there is always a probability of incurring losses any day. Hence if you are an equity investor, you must learn to live with losses for extended periods of time. Those who find this difficult must stick to safer asset classes.

For those who are willing to take the risk, there are better ways to deal with losses. Rather than focussing on the stocks which are at a loss and trying to make up for it, Dan Ariely, Professor of Behavioural Economics at Duke University, has an interesting suggestion. He recommends treating the portfolio value that you have every time you assess it, as your fresh capital. He then asks you to consider if you were to allocate that capital, how would you go about. If that capital was in cash instead of stocks, would you be investing in the same stocks that are at a loss? He, thus, recommends a forward-looking fresh approach to investing without the burden of considering past losses. The objective here is to progress versus the ‘previous day’. Not try to make up for losses made in recent months or years.

Base-rate neglect

This refers to a fallacy where individuals tend to ignore statistical and other widely-prevalent evidence, in favour of only new or recent information they have been exposed to. According to the famous Wall Street Investment Strategist and Author, Michael J. Mauboussin, ‘people who have information about an individual case rarely feel the need to know the statistics of the class to which the case belongs.’

For example, as a spate of unprofitable or thinly-profitable new-age companies were hitting the bourses last year at 40-60 times sales, investors were more driven by the narratives built around the companies, which is the recent information they were exposed to. Flashy growth forecasts and DCF models were shown as a basis to justify their valuation. But most of these forecasts reflected pure hopes about the future, than what statistics of similar companies from the past indicated.  

A simple analysis of data of high-growth companies from earlier decades clearly proves that statistically, the probability of a company listing at such high multiples and continuing to give good returns doesn’t have much of a precedence. Yet the voices based on data and statistics were drained out in the euphoria and frenzy. But now, with inflation taking hold and interest rates on the rise, fundamental value is now surfacing across global markets. Many of the much-hyped frothily-valued companies in the US markets (such as - Peleton, Zoom, Affirm, Virgin Galactic, Nio, Fastly, Palantir, Rivian) are down 80-95 per cent from their peak levels when they were given abnormal price/sales multiples. Many of their Indian counterparts too have been causing a lot of pain for investors in recent weeks. Some of them can fall further sharply too.

How to address

When it comes to markets, ultimately fundamentals trump everything else. Post-euphoria, stock prices have to revert to fundamental value. So, if you are a long-term investor, the only things that should matter to you are data, statistics and intrinsic value. Not grand stories built around companies. The only way to deal with this bias is to statistically validate your decisions before investing in a stock.

Attribute substitution

When faced with a particularly complex or demanding decision, people tend to substitute an easier decision in its place. For example, if instead of analysing a company’s valuation, balance sheet and impact of numerous economic variables on its future prospects, you base your investment decision on simple factors like say, the sector is still unpenetrated in India, then you are likely engaging in attribute substitution.

This pretty much is the way many investment ideas are sold in markets. During 2006-07, a lot of real estate, power and infra stories were sold on the basis of how low housing penetration was in India as compared to global averages, how per-capita power consumption in India was so low, how airports were the next best bets etc.This did not necessarily play out in favour of the respective stocks. A rigorous analysis would have made one factor the impact of economic slowdowns, inflation and interest rate increases on these companies. If you check out any of the RHPs and management presentations of recent IPOs, it’s the same story of low penetration in India. What these do not reveal is what will be the impact of different economic scenarios on company and stock prospects.

How to address

Lower the processes involved in an action, higher the probability of bias. Mobile apps have made investing so easy and thereby provided scope for more biased decisions. Analysis is not easy. But skipping this difficult part in investing will be counter-productive. Ways in which one can address this is by taking time to go through some of the grind, or relying on trusted advisors, analysts or material that can do the work for you. If you miss an opportunity that way, it’s still okay. At the end of the day, missing that potential gain will not be as painful as incurring a real loss.

Dealing with uncertainties

Factor-based investing/disaggregated approach to investing, wherein stocks are bought/sold based on weighting of multiple factors rather than just one main driver attractive in the stock, have proven to be successful investing strategies in the long run for many institutional investors. Thus, investors keen on mitigating biases must have a process to begin with. It could be as simple as relying on a trusted advisor who picks stocks on this basis, or building a multi-factor approach yourself. Further the process needs to be followed in spirit and substance without any exceptions. 

Another approach that can help is in acknowledging our short comings. Prediction in general is a fool’s errand. While referring to uncertainty and constraints in predicting the future, legendary physicist Stephen Hawkings once famously said, “Not only does God definitely play dice, but he sometimes confuses us by throwing them where they can’t be seen.” On a daily basis, nowhere is this effect of uncertainty felt more prominently as the stock markets, where almost everyone from seasoned investment professionals to novice investors to astrologers have a view on how stocks will move for the day, week or near future, but something different happens most of the times. Yet, there is relentless pursuit in trying to predict the movements, irrespective of the number of times one has been wrong in the past. Being humble about our predictive abilities and being open to a completely contrarian market movement before investing can also help deal with biases. 

Published on May 14, 2022
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