However, this theory is not true for many, especially investors, who can be have irrationally. Let's examine the biases that can lead to investing mistakes.
Anchoring
The concept draws on our tendency to stick to or "anchor" our thoughts to a reference point. A completely irrelevant number in our head tells us what is doable and what is not. For instance, if a share hit a new high of say `1,200, and then fell to `700 following an US FDA letter, the new price looks cheap, because we are anchored on that price of `1,200.Similarly, when we buy a pair of sports shoes for `12,000, it is very easy for the salesman to push us a pack of three socks for just `999 because we are anchored on `12,000 and 999 looks reasonable.The same pack of socks could well be available for `444 on sale elsewhere.
Mental accounting
This is the tendency to divide money into separate accounts based on a variety of subjective criteria. It applies to both source of money and what it is earmarked for. So it becomes easy for your bank's relationship manager to convince you to leave `7 lakh in a liquid fund (for an emergency) while convincing you to borrow `10 lakh to buy a car. According to theory, individuals assign different functions to each asset group. This can make investing both inefficient and irrational. Then there is not understanding the importance of compounding, or the amazing impact that a 13% CAGR can have on a portfolio if this is achieved for say 30 years instead of 20. Not understanding the power of `n' over `r' in the compounding formula is part of this behavioural bias.People talk of `bonus' shares as something they got free. Or blowing up the dividend income saying, "I have found this money".
When you get an income tax refund, you should be asking `why did I pay so much of advance tax?' instead of blowing it up partying or eating out. It gets worse when people lose money in their `trading portfolio' but will not book profits in their investing portfolio. This leads us to another bias called `loss aversion'. This bias says we are not willing to admit, even to ourselves, that we made a mistake in buying the share in the first place.
Overconfidence bias
We systematically overestimate our ability to do certain things. Men tend to overestimate their investing skills and women their culinary skills, and there is no empirical proof of either. Women may make better investors and men better cooks, but we are conditioned to think in fixed boxes. In a class of 50 people if you ask how many of you are above average, you will find 45 hands going up, not 25. We tend to think: `I have been in the markets for 22 years...and I know everything'. It is amazing how long market experts have been predicting market movements yet the business channels attract a huge viewership at 9 am just when the market is about to begin. The way to overcome this is by maintaining an investment diary. Revisit your own predictions made about two years ago. Even better, click on articles of 12-15 months ago and see how many predictions were right.
Loss aversion
We feel there are more things which can be bad for us than things that are good for us! Let's assume you have invested `5 lakh in a particular stock, and `1.5 lakh in another. The first investment has done very badly and is now down to `3 lakh. The second has done well and is now worth `3 lakh. Now, you need `3 lakh. Which share will you sell? Loss aversion bias says you will sell the second investment far more easily than the first. To avoid this be very clear that you are a long-term investor and not a shortterm speculator. Treat the `book' profit and `book' losses as real profit or loss, not notional. Then bearing the loss becomes easier.
Confirmation bias
Is it "seeing is believing" for you? Sadly, the eye is not the brain. The brain dictates to the eye what to see, so you could well miss the 800 pound gorilla when your brain is processing something else. Our minds have a habit of introducing biases in processing certain kinds of information and events.
Hindsight bias
After an event is over, you feel it was something that could have been easily predicted. In reality, there is no way of predicting what is about to happen. For example, no expert thought that the US could stay with zero to negative interest rates for 8-9 years. Or when the price of oil was $130, none of us thought it would hit $40 in two years. Once the event happens people suddenly see why it happened. Maintaining a diary and recording what you think will happen is a nice way of preventing hindsight bias. Read your diaries and see whether your predictions were anywhere close to reality.
Gambler's fallacy
When people contemplate buying penny stocks, they think a `10 share will become `20. They completely discount the probability of that happening.So they also look sadly at the IPOs that they missed Maruti, Infosys, HDFC Bank and Hero Motors. However, if you had invested `1,000 in all the IPOs since 1992, chances are that overall you would have lost money. Just take a look at the graveyard of IPOs. We forget the role of chance. The next question to ask of course, what is the probability that we would have held on to those shares for 20+ years.
Herd behaviour
A legacy of our prehistoric roots. A group is moving together, and one person sees a brown animal behind the bush. Is it a tiger looking for food or is it a deer which can be food? No one has a clue. So one person says `tiger' and all run and your ancestor is saved. That mentality still continues. So when your neighbour tells you he made money buying TCS, you also feel you can too. Well, now you know why you think like that.
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