Investment Biases: Human Behavioural Aspects that affect the Investment Decision of Individuals
It is assumed that individual investors while making an investment decision which could be investing money into different investment avenues like shares, mutual funds, debt funds, bank deposits, gold, real estate etc makes a rational decision. They consider all the factors that might affect the risk and return attached to that investment option. But in reality, there are different investment biases that affect their investment decisions. The existing literature on behavioural finance literature supports that rationality is not a natural thought process and that biases and heuristics lead to predictably irrational choices. Behavioural finance as an area focuses on explaining these irrational behaviour and predictable errors made by investors while making their investment decisions.
In this blog, I would be discussing some of these biases that might be influencing us (as investors) while taking our investment decisions.
The first one is the Herding Behaviour wherein we make our investment choices based on the choices made by other people (investors). For instance, we buy the shares of those companies or sector that other investors have already purchased or if we see other investing in real estate, we also follow the crowd. This bias arises out of human instinct to achieve social conformity and also the lack of confidence in one’s own judgment. As individuals, we might believe that a large group of investors could not be wrong and thus following what others are doing is a safe choice. This bias leads to a bubble in an investment class leading to losses for the late entrants as they purchase them at the peak prices and thus suffer the most when the bubble busts.
Second is the Conservatism or Loss Aversion; wherein our investment choices are based on inherent fear of not losing money. Due to this, we would avoid certain investment classes where there is some probability of losses though they have good return prospects as well. Thus, individuals with this inherent bias choose only stable investment options though they offer lower returns.
Third is the Momentum Effect; wherein individuals believe that the current trend in terms of movement (return) of the investment class will continue for the coming period as well. This means that if the prices of that shares or any other investment class is increasing, it will continue to increase and thus a good option to invest in and on contrary if it is falling it will continue to fall so it is better to exit that investment class even if it means incurring losses. This bias arise out of our human psychology that applies in our daily life also that during good times we are optimistic that this good time is there to stay forever and during tough times we get depressed and surrounded with negative thoughts that circumstances will never improve. This momentum effect bias amongst investors will lead to sharp rise and fall in prices of various investment classes.
Fourth is the Snake Bite Effect; wherein the investors are unwilling to invest money into those shares or other investment classes where they have suffered losses in the past. As investors if we have burnt our fingers in an investment, due to the snake bite effect, we would avoid that investment in the future also even though the scenario and the investment proposition have completely changed.
I have listed some of the important investment biases in this article, though there are many others that have been researched in this field of Behavioural finance which I would be discussing in my other blogs in this area. This article hopefully would be helpful for the prospective investors in ensuring that they overcome some of these biases and take a more rational investment decision.
Written by:- Prof. Ridhi Khattar, Assistant Professor, Faculty of Management Studies, MRIIRS