Behavioral Biases and Anomalies for a Rookie Investor

Traditionally, investors are assumed to be rational and risk averse i.e. they dislike variation. When we say a stock has a variation of 10%, we mean it can go up or down by 10% over a certain horizon. Though individual investors are generally not found to be rational but are more loss averse rather than risk averse. Simply put, they dislike loss of 10% more than a gain of an equal amount. Here the concept of Behavioral bias comes into light. These biases affect financial decisions of individual investors. The most common behavioral biases are –

1.       Mental Accounting

Investors often have different instruments of investments and classify these instruments into separate mental accounts rather than considering it as an entire portfolio. The riskless components are separated from its risky components. So they don’t set off the high risk and potential gain on equity with the safe and secure returns on FDs or Bonds.

2.       Gambler’s Fallacy

If the stock is decreasing continuously, instead of cutting the losses you think that since the decrease is more frequent right now, it will be less frequent in the subsequent period. This is based on the assumption that previous failures indicate an increased probability of success in the future.

3.       Disposition Effect

Investors are willing to realize gains but are unwilling to realize losses. Say you bought a stock for Rs. 100. It went down to 80 then to 60 and you still don’t cut off the losses thinking it will turnaround in the future. Now say it goes from 100 to 110 and you immediately book your profits.

4.       Representativeness

Investors classify new information based on past experiences and assume that good companies are good investments. Although this may work in long-run, but in short-run certain other factors should also be taken into consideration. A good investment is only good when the market agrees with you.

 5.       Conservatism

Investors keep their initial views or forecasts without incorporating new information and react slowly to change. Stock markets have a very dynamic environment and every new piece of information must be considered as the markets reflect the changes almost instantaneously.

6.       Hindsight Bias

People may see past events as being predictable and give themselves a false sense of confidence in their ability to value stocks. This often happens because they don’t remember their exact beliefs and tend to fill in the gaps by selectively gathering favourable information.

These behaviors are fairly common for beginners and must be avoided in order for them to become a prudent investor.

Click here for government certification in Accounting, Banking & Finance