Due Diligence. Manic market: Investment biases to avoid

The coronavirus panic has battered the stock market, and many investors would understandably be nervous.

In volatile markets like this, there is an increased risk of giving in to emotions and taking wrong decisions. Here are some behavioural biases that one should be wary of.

Anchoring

Consider a case where you bought a stock at ₹100 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 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, and this could lead to wrong decisions and losses.

Let go of these undesirable anchors. When the facts change, change your mind and your investment approach.

Rely on fundamental analysis based on updated information, and act accordingly.

Loss aversion

In the above example, say the stock price falls from ₹120 to ₹80 — below your buy price of ₹100. And it seems headed down further to ₹50. You must ideally exit 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.

But 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.

Do not fall into the loss-aversion trap. It’s difficult, but learn to overcome the mental pain of recognising loss, if need be. 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.

Herding

Say, a once-favoured stock has been pounded badly due to the selling-spree. You held out so far, but now you fear that you 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. But you worry it could be right, too. How do you decide? Not by following the herd blindly, but by making an 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.

Confirmation bias

People generally have a tendency to see and hear what they 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 central banks’ rate cuts to bolster our arguments in favour of growth bouncing back. This could lead to risky bets and not paring exposures to weak stocks despite other negative news. Others may focus only on negatives such as the global coronavirus spread and poor earnings growth of companies — discarding positives such as India’s long-term growth potential and reasonably good control over the virus spread in the country so far. This could lead to their exiting even from strong stocks.

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

Risk aversion

Among the undesirable outcomes of volatile 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 relatively riskier assets such as equities. They may think of stopping their mutual fund SIPs. This is unwise.

Markets pass through ups and downs, and a long-term horizon should help even out the creases.

A diversified portfolio with well-thought out asset allocation that includes exposure to riskier 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.

Volatile markets, are in fact, a blessing in disguise for those who invest regularly through SIPs and have a long-time horizon. That’s because the ‘cost-averaging’ principle works to the benefit of investors in weak markets, helping them get more fund units for the same regular outgo. So, keep those SIPs going in funds with a good track record.

Recency bias

Say, the stock of a company with strong fundamentals and good long-term growth potential 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 this 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 see you letting go of winners.

Don’t assume that recent events will inevitably continue. Events should be viewed independently, and continuity should not be assumed.

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