The human brain is remarkable: it has allowed us to survive for thousands of years, and achieve such unimaginable feats as landing on the moon. However, humans also think in certain ways that at times prevent them from making rational judgements. In primitive times, these heuristics (mental shortcuts) helped us make quick decisions in dangerous and stressful situations. However, in modern times, those very “fight or flight” reflexes can have a profound – and sometimes detrimental – effect on how we decide and act.
An online search revealed 188 known cognitive biases, some of which can manifest in an investor’s decision-making process and negatively impact his investment outcomes. Take for example the tendency for a majority of high net worth investors in India to continue to hold significant amounts of physical real estate assets
in their portfolios, even though both the current and future outlook for this asset class remains lacklustre. Due to their high level of investment in real estate, such investors' portfolios are often inadequately diversified, and they also miss out on the opportunity to earn much higher returns by spreading their investments among multiple asset classes. This is status quo bias which causes investors to hold assets that they feel familiar with, or which they are emotionally fond of, so much so that they are prepared even to compromise on their financial goals to hold them.
An intuitive choice is not always right
What can investors do to overcome these cognitive biases? The first and most important step is to acknowledge these biases. It begins with gaining an awareness and understanding of what these systematic errors are.
The volume of information in existence, as well as the increasingly accessible ways of gathering them, means that the challenge lies not in the availability of data, but in the way we process them. For individual investors, cognitive biases have the potential to impair their ability to both gather information and make high-quality investment decisions with that information.
The three most common examples of “mental shortcuts” when gathering information are confirmation bias, anchoring, and home bias. Confirmation bias is the tendency to focus on ideas that confirm our preconceptions, while ignoring those that contradict our beliefs. For example, an investor
will seek out confirmation from news and analysis to validate his preconceived notion that a particular stock is a good investment, while ignoring any negative information that may go against his existing bias for the stock. This may result in the investor
holding on to those shares even when the organisation’s performance and share prices are falling.
Anchoring, on the other hand, occurs when an investor
makes an investment decision just by relying on one piece of past information, say, last year's return of an asset.
When making investment decisions, investors may also fall prey to overconfidence bias where they tend to overestimate their ability to precisely value companies, or predict earnings and growth potential. Overconfidence bias comes to the fore especially during bull markets, when investors become overweight on equities, or on risky segments of equities like mid- and small-cap stocks, and ignore the risks in those segments entirely.
Gather information from diverse sources
While plenty of research exists to help us identify our biases, what is also clear is that this reliance on instincts to think quickly on our feet and take investment decisions in haste cannot be changed entirely. The good news is that we can mitigate its impact. In investment-related decision making, for instance, individual investors can, for instance, leverage on the expertise and experience of professional wealth advisors.
How can this diversity be achieved? Firstly, there must be diversity in knowledge. One must actively seek information from as wide a range of sources as possible, reflecting varying – and sometimes even contradicting – opinions and views. An open-platform approach to gathering insights means that wealth managers can harness the collective intelligence of existing perspectives, before considering and debating through each of them to form the team’s house views. Investors, thererefore, have access to not just mere information, but relevant insights that can help them benefit from better investment decisions.
Diversity must also be applied in the makeup of the team, from each individual’s culture and nationality to their work experience, and the way he or she thinks. A research paper by the Proceedings of the National Academy of Sciences of the USA (PNAS) found that stock pickers who were part of diverse teams were 58 per cent more likely to price stocks correctly as compared to those in more homogenous groups.
Past events such as the speculative bubble in technology stocks in 1999-2000 and the 2008 financial crisis have shown us that market behaviour can sometimes defy economic rationality, because investors do not always react and respond in ways that are completely logical.
Biases that mar investment decisions
The tendency to believe that an asset class that has performed well in the recent past will continue to do so in future as well
Holding on to an asset in the hope that it will recover to its purchase price, instead of selling and cutting losses
The tendency to base decisions on information that is available easily, instead of making the effort to consult diverse sources
Tendency to seek comfort in what the majority of people around are doing instead of developing the ability for independent thought and action
After buying a stock in which he lacks conviction, because he bought it based not on his own research but on tips, the investor
gets uncomfortable and sells it, thereby generating high churn
The writer is managing director & head, Standard Chartered Private Bank, India. The views expressed are personal