Investors are inundated with an unprecedented volume of data that does not necessarily help them in making sound investment decisions. The views available in public domain are mostly global in nature and does not account for the general and cultural preferences of an investor. This is further skewed by biases, leading to a lack of diversity in input and instead fostering overconfidence. Cognitive biases are systematic mistakes that affect the way investors reason, evaluate, remember, and make untimely decisions.
The cognitive biases when gathering information are:
Confirmation bias: This is the tendency to search for, interpret, focus on and remember in a way that confirms our preconception. An investor whose investment holdings are concentrated in a specific sector or group of stocks may only absorb good news and ignore bad news regarding these investments.
Anchoring: Tendency to focus on one piece of information when making decisions, usually the first piece of information obtained on the subject. An investor buys a stock because it has fallen by 20-30% in, say, last 3-6 months. Here the investor is incorrectly anchoring to the stock price prior to the decline, or to the price trend in the last 12-26 weeks. In reality, the stock may fall further and the right anchor should be the fair value of the stock.
Familiarity/home bias: Tendency to overweight an outcome based on perceived familiarity with it. Investors holding India or sector- or funds-centric portfolio because of their familiarity with the same.
Cognitive biases when deciding on an investment are:
Endowment effect: Individuals often ascribe a higher value to their possessions merely because they own them, which can influence decision-making, particularly in economic transactions and negotiations. Employees of a company might continue to invest in its share because they work for the company and they see the vision, disregarding the valuation of the company, or even the financials.
Overconfidence bias: The tendency to overestimate the precision of our own valuation abilities. A trader operating in financial markets is certain that their prediction about a stock trending upwards is accurate. Even though market predictions are uncertain by nature, the trader invests heavily. This confident risk-taking, despite the volatility of markets, is a typical showcase of overconfidence bias
Hindsight bias: This is the inclination to see past events as being more predictable than they actually were before they happened.
Here is what an investor should do to manage cognitive biases. Stick to a time horizon as per risk appetite and asset allocation; time in the market is better than timing the market; stick to the defined strategic asset allocation; and manage extreme emotions during market volatility
Investors, rather than seeking more information, should look out for high-quality and diverse insights that enhance their decision-making capabilities. The more intricate a problem, the more cognitive diversity becomes crucial in refining the investment decision-making process. Investment decisions are inherently probabilistic, uncertain, and complex - though it may look simple due to biases mentioned above. A decision-making approach that embraces diverse views on economies and investment products, incorporating signals from various perspectives, is essential for achieving good investment outcomes.
Amid all this, what is the role of the investment adviser?
To remain relevant, investment advisers must consider not just the investor’s financial goals and risk tolerance but also the investor’s culture and aspects of their personality as they play a key role in appropriate advice. The investment adviser should steer investors away from overemphasizing what’s familiar in investment, so that investors don’t miss the opportunity to enhance return or reduce risk. They should recognize the importance of cognitive diversity in navigating the intricate landscape of investment decisions, incorporating a broad range of views to enhance the overall decision-making. A decision making process that embraces diversity of views regarding investment views, leads to correcting biases and a better decision outcome for investors.
Harsimran Sandhu is professor & area chairperson finance, IMT, Ghaziabad.
Here’s your comprehensive 3-minute summary of all the things Finance Minister Nirmala Sitharaman said in her Budget speech: Click to download!