At the Morningstar Investment Conference 2018 that was held in Mumbai last week, Steve Wendal, head of behavioural sciences at Morningstar, gave a presentation on behavioural biases faced by investors. Behavioural biases refer to habitual reactions that you may have to various situations. According to Wendal, some of the most common behavioural patterns of people in context to everyday choices perhaps don’t work well when applied to investing. Here are three most common biases Wendal cited.
Following the herd
In many situations agreeing with the majority is what can lead to the most effective choice. For example, in a shop with discount counters, the counter with the bigger crowd is likely to be the one with a greater discount or from among two restaurants the one with a bigger crowd is likely to be the one with tastier food. However, this behavioural bias is unlikely to work each time you make a financial decision.
In fact, when it comes to investing in capital markets, it is often said that one should not follow the herd. Rather a more prudent approach is to invest based on your specific requirements and within your specific limitations. Just following what everyone else is doing or investing where the crowd points can have the opposite of the desired reaction.
Price matters most
While buying a product, a primary point of comparison is price. While a section of society looks for discounts on products they buy regularly, for another section a high price signifies better quality. However, when it comes to buying financial securities and assets, the value and not price takes on greater significance. The price of listed securities, for instance, can change on a daily basis, but the long-term value they can potentially deliver does not shift.
One needs to look beyond price at the income stream like dividend or interest and the earnings growth potential in case of stocks. The absolute price of a security compared to the price of another will tell you very little.
Confirmation bias is the tendency of individuals to look for signs that affirm a belief they already hold, perhaps by ignoring signs to the contrary.
While this works well, say, if you are buying branded clothes or choosing the best medical care, in case of investment options one can’t always use past experience or perception. A listed stock, for example, which has given good returns in the past two years, may not continue to do so for the next two. Its performance going forward will depend on the underlying company’s ability to continue delivering earnings growth which is at least as much as what it did in the past two years. If growth slows down, the stock price will fall too. Hence, once a good investment isn’t always going to be so.
Before deciding to buy a financial product, you must carefully evaluate each option independently for all its characteristics such as potential return, liquidity and taxation.