Confirmation Bias -
A tendency to look for information that supports your belief or conclusion. For example, if you support a political party, you will choose to look for information that supports that party or upholds its beliefs and actions . Similarly, in case of confirmation bias in the investment world, if you get a message from your 'investment expert' friend that 'XYZ' mutual fund scheme will perform very well as it invests in the mid-cap industries, you will look for news and information about mid-caps doing well or positive performance of XYZ MF scheme. If you have decided that a particular stock is going to do well, you tend to search for confirmation on your belief from more than one source. Once your decision is validated by multiple sources, you do not want to process information that says otherwise. You may also find it easier to find and understand data that conforms to the existing belief.
How can it affect your Portfolio –
Wrong choice of investment products leading to imbalance in investment portfolio.
Information that opposes the belief is seen in negative light which means it is not acted upon rationally.
How can you overcome it -
Be open minded to facts and analyse them properly before reaching to a conclusion.
As a prudent investor, you should seek contrarian opinions and evaluate all pieces of information logically.
Familiarity Bias -
Once we are used to certain shops or brands, we stick to them. Even though there might be better or newer products. This is familiarity bias. It is a common bias in investing too. Some people buy stocks of their own company or sector they work for just because they are part of it. When there is too much information or news about the performance of some investment product, we believe that it is a good product without really understanding it properly.
How can it affect your Portfolio -
- High concentration on a specific investment product.
- Less than optimum returns if the product backfires.
- Check with your financial advisor about the features and potential of the investment product to get an unbiased view.
- Check your portfolio. If there is too much concentration on one product or type of product, offload some of it and diversify your asset allocation.
The tendency of a person to overestimate the accuracy of their ability to predict an outcome. A person believes that he or she predicted the outcome once the event occurs even though they may not have predicted it based on facts. It might have been a guess. Hindsight bias also occurs when they had two or three outcomes in their mind but once one of the outcomes occur, they start believing that they predicted it. For example, in an IPL cricket match there can be three outcomes. You might be rooting for your team to win and when they win, you declare you knew it would happen which may not be entirely correct. You were just wishing that they win.
How can it affect your Portfolio?
- Overconfidence in ability to make investment related decisions leading to mistakes
- Overestimation of ability to predict financial events leading to risky actions on the financial front
- Assess all investment options rationally. Check for contrarian facts and numbers.
- Identify and acknowledge mistakes made in the past because of hindsight bias and learn.
The tendency of a person to value what he owns more than its real value. Economist Richard Thaler demonstrated this by giving the example of a man who bought a bottle of wine for $5 from a wine merchant. The same wine merchant offered him $100 for the same bottle a few years down the line. He refused to sell. When people sell what they own, they feel that they are losing something which is theirs.
Some people do not sell shares/mutual funds that they have inherited even though they may not fit in their investment portfolio as they get a sense of belonging. A person might buy an investment product at Rs. 300 expecting to sell it at Rs. 500 within a certain timeframe. If the product reaches the price of Rs. 480 but stays there for some time threatening to go upward or downward, the person may not sell it even though the price is pretty close to his target. The endowment effect kicks in and he feels that he will lose Rs. 20.
How can it affect your Portfolio -
- Mis-timed selling that can affect portfolio returns.
- Being stuck with assets that do not give optimum returns.
- Acknowledge that you get the right value when you sell it at the right time. The investment proceeds can be utilized optimally.
- Keep emotions separate from investment decisions.
Have you faced any of these dilemmas? Have you overcome these biases?
In the next post, we look at some more behavioural biases – Loss Aversion, Herd Mentality, Sunk Fallacy and Self Attribution.