Personal Finance

Behavioural biases to overcome in a bear market

Anand Kalyanaraman | Updated on August 04, 2019 Published on August 04, 2019

A measured, logical approach to investing can help avoid behavioural pitfalls and navigate the current tough market conditions

The stock market is on a rather weak wicket and many investors would understandably be getting the jitters. In times like these, there is increased risk of giving in to emotions and taking wrong decisions that could hurt you financially. Here are some behavioural biases to watch out for and avoid.

Herding

Say, the world and its uncle has been selling a once-favoured stock, and it has been hammered badly. You held out so far, but now you fear that you could be wrong and may be left holding the can. So, you too join the selling bandwagon and exit the stock. This is a case of herding bias — doing what others in the group are doing. This is something to be avoided.

That’s because there is a good chance the majority is wrong, as it often is. On the other hand, it could be right, too. How do you decide? Not by following the herd blindly, but by making an independent, objective assessment based on data, the stock’s valuation and the company’s prospects. Read and research before you decide. If such an assessment makes a case for exiting the stock, don’t hesitate to do so. But if it shows that you may be better off holding on, don’t sell a potential winner. Having your investment strategy in documented form, and keeping records of your past wins and losses with proper reasoning, can help you be objective and avoid the herd.

Anchoring

Now, consider another case where you bought a stock at ₹100 a piece and then it rallied up to ₹150. You thought of exiting at this level, but before you could, the stock began slipping and has now fallen to ₹120. Say, this company is in trouble and there is a good possibility that the stock could go all the way down to ₹50. The ideal thing for you to do would be to exit as soon as possible at ₹120. But you are fixated with the high of ₹150 — which you think is a fair price for the stock — and refuse to sell below it. This is called anchoring bias. You have anchored on to a number and this influences your subsequent decisions. You are unwilling to change with the circumstances, and your stubbornness could lead to wrong decisions and losses.

It is in your interest to let go of these undesirable anchors. When the facts change, you must change your mind and your investment approach. Instead of holding on to past glories that may not return, you must rely on fundamental analysis based on updated correct information, and act accordingly.

Loss aversion

Now, in the above example, say the stock price falls from ₹120 to ₹80 — below your purchase price of ₹100. The stock seems headed down further to ₹50. You must, in good sense, exit in quick time and cut your losses. But you don’t. It’s because you are exhibiting a common behavioural bias known as loss aversion. That is, you tend to avoid recognising losses to the extent possible. This behaviour is understandable, because the pain of loss is said to be twice the pleasure of gain.

In the bargain, you tend to hold on to losers for too long or even buy more of them in the hope of breaking even. So, you may continue buying losing stocks on ‘dips’ to reduce ‘average cost’. Loss aversion also leads to selling winners too quickly to book gains, and in the process losing out on more potential upside in the investment. All this ends up hurting the investor.

It is important to not fall into the loss-aversion trap. Learn to overcome the mental pain of recognising loss. Cut losses, if you have to. Base decisions on realistic expectations than on past events. Make an objective analysis of whether your investment and its valuation make sense.

Recency bias

Consider the case of a blue-chip company with strong fundamentals and good long-term growth potential. The stock of this company had done quite well until the bears gripped the market. In recent times, the stock has also fallen back due to the broader market weakness and poor sentiment. But the company has the muscle to weather the storm and there is good potential for the stock to bounce back. Still you decide to sell the stock, thinking that what has happened in the recent past is bound to continue. You are displaying recency bias — giving more importance to recent events as they are more easily recalled. This bias could cause you to let go of winners.

It is not correct to assume that recent events will continue. Events should be viewed independently and continuity should not be assumed.

Confirmation bias

Many of us have a tendency to see and hear what we want to see and hear. So, we focus on information that reinforces our beliefs while disregarding anything that counters our narrative. This is called confirmation bias. For instance, some of us may focus only on the RBI’s rate-cut supportive stance to bolster their arguments in favour of growth bouncing back. This could lead to risky bets and their not paring exposures to weak stocks despite negative news. Others may focus only on negatives such as poor earnings growth of companies, discarding positives such as India’s long term growth potential. This could lead to their exiting even from strong stocks.

Confirmation bias can be mitigated by questioning our own assumptions in an honest manner and seeking out opposing opinions. It is essential to incorporate the correct inputs in decision-making — even if it is not to our liking and runs contrary to our assumptions. For this, it is essential to have an open mind, be humble and set aside one’s ego while investing.

Risk aversion

One of the bad outcomes of bear markets is that some investors, especially new ones, display risk aversion after a bad return experience. That is, having lost money, they tend to shy away from risky assets such as equities. They may think of stopping their mutual fund SIPs. This is unwise. Markets pass through cycles, and a long-term horizon should help even out the creases.

A diversified portfolio with a well-thought out asset allocation that includes exposure to risky-but-high return-potential assets such as equities is essential to build a healthy corpus over the long run. Also, it is a mistake to stop mutual fund SIPs in tough market conditions. Bear markets, are in fact, a blessing in disguise for those who invest regularly through SIPs and have a long time horizon. That’s simply because the ‘cost averaging’ principle works to the benefit of investors in bear markets, helping them get more fund units for the same regular outgo. So, keep those SIPs going in funds with a good track record.

Published on August 04, 2019
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