3 Common Investing Biases – Loss Aversion, Herding & Choice Paralysis

BIAS: Human tendency to be inclined or hold an unconscious partial perspective followed by inability to consider the virtue of alternate point of view.

Investing biases hinder your chance of making investment returns as they limit your analysis.

3 Common Investing Biases to be Conscious About:

[1]  Loss Aversion Bias

investing biasesLoss aversion refers to investor’s tendency to strongly avoid losses even if that is at the cost of suffering a deeper or a bigger loss. To an average Joe, this definition may be inferred as a rather pragmatic and helpful advice, however, this tendency leads to the infamous disposition effect or as one may call it Investor’s blasphemy.

It is fairly simple to understand (but may not be as simple to deal with). For instance, consider you buy a stock X priced at Rs. 100 with the target sell at Rs. 120. But instead it goes down and reaches at Rs. 80. Now, you have two options:

  • Accept and minimize your loss by selling it at Rs. 80.
  • Wait for the stock X (with declining price) to reach back over Rs. 100 and then sell it.

Option b) is what a loss aversive investor would do. This would end up increasing the loss substantially. However, if the same stock would have reached Rs. 120, a loss aversive investor may or may not sell at a profit of Rs. 20.

Loss aversion leeches on investor’s inability to make a decision. In fact, more harm is caused by indecision than wrong decision.

REASON: Empirical data indicates that loss is almost twice as psychologically powerful than gains. That is, in above example, the mental agony of loss of Rs. 20 is more than the pleasure of gaining Rs. 20. This behavioral theory was developed by Daniel Kahneman and Amos Tversky in 1992.

“The most important thing to do if you find yourself in a hole is to stop digging.”

̶  Warren Buffet

[2]  Herd Behavior

Animals move together and follow each other in a herd, often started by a leader or even sometimes coincidence. Similar concept holds true in the realm of finance. If you are one of the investors who follows the “everyone else is doing it” logic for buying (or selling) an asset, chances are you are a herd investor. Herd investing in my view is not very different from speculation.

Herd investing is both, a cause and justification of many surprising movements in the market. The most profound example is the DotCom Herd: In 1990s VCs and individual investors were investing enormous sums of money in the booming internet industry. Some of these DotComs didn’t have a functional business plan and ended up damaging serious investor money. Another latest example would be dumping of $700 million of Apple shares by famous Carl Icahn due to concerns with China. Moments after media was hit with the news in April 2016, the iPhone maker’s stock price went down over 3%. Icahn’s move to sell his Apple stake caused many individual investors to bail out and triggered a sudden decrease in tech giant’s stock’s demand. This was typical herd behavior by these investors.

investing bias - herd behaviourThe graph shows the increase in price of a stock when it gets crowded by investors/buyers. Similarly there is a decrease in price when there is a mass selling of a stock. The investors’ who make (or save) the most money are the initiators (leaders) of these trends. Corollary to this, we easily say that all Long Term Investors do not exhibit herd behavior.

Opposed to Herd Investing, there exits Contrarian Investing – selling or purchasing assets in contrast to prevailing market sentiment at the time.  These investors believe that some investments are over/under valued due to the current market sentiments. In due time, Contrarian Investors evolves to eye the market laterally and therefore learn to use Herd Investors’ market’s outlook to their advantage. Warren Buffet is considered to be the best Contrarian Investor of all time.

REASON: There are two obvious reasons why some investors are biased into herding:

  • Human Nature: No matter how inarticulate this strategy looks, we as humans are evolved to follow the crowd. It is only a natural instinct (and not just in finance). It is corresponding to choosing the same ice cream flavor as your friend or sibling as a child. And similar to that this strategy can also give you a good result (satisfactory return = $$).
  • Safety in Numbers: This hypothesis, although criticized, has worked through majority of history. An investor is always looking to hedge their risks and is more likely to accept losses if other investors were struck with same losses. This makes him/her look for more people investing in the same stock as them. Also, that’s why we see more and more investors recommending their stocks on online business websites. This is equivalent to getting punished alone in class versus getting same punishment with whole class; we all chose the latter.

[3]  Choice Paralysis

Innately, we know that more the merrier i.e. the more choices we have the better it is. But ever since the flare of internet and glut of information, the more common belief is: Less is more. When investors are apprehended with a large number of choices for any financial product (equity, bonds, mutual funds etc.), an easy decision is transformed into a difficult one by the vice of decision paralysis rippled from choice paralysis itself. For instance, when you approach a toll bridge in your car and are unable decide which queue you should join. This choice paralysis may happen to you for a split second in your car, but it takes up far more time than that in finance.

Choice paralysis is often followed by Herding. When large numbers of investors are struck with large number of stocks (or any other financial product) choices, majority of them will long/short the same stock as that is more convenient and appealing to the majority than any other combination of investments choices by the group.

REASON: Main reason for choice paralysis in finance is elementary one, that is, the number of choices has increased with the increased competition in the economy. This increase is accompanied with overload of information through means of internet connectivity. Thus, in this time and day, any newbie investor takes fair share of time for starting their first profitable portfolio. Advancing forward, we realize that holding the large amount of data available responsible for choice paralyzing would be rather irrational. Additionally, we can see that all investors are biased by choice paralysis. Putting these factors in aspect, we can conclude an ideal investor should know how to filter the information they are provided. In current times, we all presented with same amount of information but only a very few among us know how to analyze it better than most.

“It’s not information overload. It’s filter failure.”

̶  Clay Shirky, writer and consultant on social and economic effects of internet

Also Read: Psychological Traits Of A Successful Stock Investor

5 Investing Rules You Should Follow to Achieve Investing Success

Written by Abhimanyu Hans